Private Equity

Outline
• Private Equity Introduction
• Structure of Private Equity
• Private Equity vs Hedge funds

• Fees and carried interest associated terms – clawback, catch up

• risks and returns of PE investments
• measuring PE risk and returns
• portfolios consisting of liquid public equity and illiquid PE.
Private Equity Introduction

Private equity (PE) investments are investments in

privately held companies, which trade directly
between investors instead of via organized exchanges.

Private equity is medium to long-term finance

provided in return for an equity stake in potentially
high growth unquoted companies
Private Equity Introduction

What is Private Equity?

• Private equity provides long-term, committed share
capital, to help unquoted companies grow and succeed.
• If you are looking to
• start up, expand, buy into a business, buy out a division
of your parent company, turnaround or revitalise a
company, private equity could help you to do this.
Private Equity Introduction
• Private equity firms are looking for investment
opportunities where the business has proven
potential for realistic growth in an expanding
market, backed up by a well researched and
documented business plan and an experienced
management team – ideally including individuals
who have started and run a successful business
before.
Illustration Pvt equity
• At inception PV Firm founder : $ 1mn
• He approaches for VC : $10 mn
• Valuation after 5 years $50 mn
• Equity that will be shared by VC and founder after 5 years : 1:10
Private Equity Introduction contd.
• The investments are typically made through a PE fund organized as a
limited partnership, with the institutional investors (typically pension
funds or university endowments) as limited partners (LPs) and the PE
firm itself (such as Blackstone or KKR) acting as the general partner
(GP).
• Private equity (PE) investments are investments in privately held
companies, which trade directly between investors instead of via
organized exchanges.
Private Equity Introduction
• Private equity is medium to long-term finance provided in return for
an equity stake in potentially high growth unquoted companies

• The investments are typically made through a PE fund organized as a

limited partnership, with the institutional investors (typically pension
funds or university endowments) as limited partners (LPs) and the PE
firm itself (such as Blackstone or KKR) acting as the general partner
(GP).
Private Equity Introduction
• The GP manages the PE fund’s acquisitions of individual companies (called
portfolio companies).
• Depending on the type of portfolio companies,
• PE funds are typically classified as buyout, venture capital (VC), or some other
type of fund specializing in other illiquid non-listed equity-like investments
• Buyout funds invest in mature established companies, using substantial amounts
of leverage to finance the transactions. VC funds invest in high-growth start-ups,
using little or no leverage.
• Finally, it is not uncommon for LPs to also invest directly in individual companies.
• These investments are often structured as co-investments into the portfolio
companies, alongside the investments made through the PE fund.
Private Equity as an asset class
• PE is often considered a distinct asset class, and it differs from
investments in public equity in fundamental ways.
• There is no active market for PE positions, making these investments
illiquid and difficult to value.
• The investments are for the long term. PE funds typically have horizons
of 10-13 years, during which the invested capital cannot be redeemed.
• Moreover, partnership agreements specifying the governance of funds
are complex, specifying the GP’s compensation as a combination of
ongoing fees (management fees), a profit share (carried interest),
transaction fees, and other fees.
Private Equity as an asset class

Private equity as an asset class is

subdivided into a number of sub-
categories including:
• Venture capital
• Expansion (or growth) capital
• Buy-outs or buy-ins
Private Equity as a source of capital –
Prospects?
• Does your company have high growth prospects and are you and your team
ambitious to grow your company rapidly?
• Does your company have a product or service with a competitive edge or
unique selling point (USP)?
• Do you and/or your management team have relevant industry sector
experience?
• Do you have a clear team leader and a team with complementary areas of
expertise, such as management, marketing, finance, etc?
• Are you willing to sell some of your company’s shares to a private equity
investor?
• If your answers are “yes”, private equity is worth considering.
 Objective of PE
The objective of a private equity fund is
• to invest equity or risk capital in a portfolio of private
companies which are identified and researched by the
private equity fund managers.
• Private equity funds are generally designed to generate
capital profits from the sale of investments rather than
income from dividends, fees and interest payments
• Private equity is predominantly about generating
capital gains.
 Objective of PE
The objective of a private equity fund is
• The idea is to buy equity stakes in businesses, actively
managing those businesses and then realising the value
created by selling or floating the business
• Private equity is predominantly about generating capital
gains.
• They generally aim to achieve capital growth, not income.
• The objective of private equity is therefore clearly focused
on increasing shareholder value.
 Evolution of Private Equity
Major Events in Private Equity
 Evolution of Private Equity
History of Private Equity
 Evolution of Private Equity
PV during Silicon Valley growth
Evolution of Private Equity
First PE Boom
Types of private equity
Types of Private Equity

Venture Capital
• Early-stage (start-up) and late stage
(development)
• Information technology and healthcare emphasis
• 100% equity
• 5+ years average investment life
Venture capital ?
• Venture capital is focused on young,
entrepreneurial companies and is an essential part
of value creation in the whole private equity
financing cycle.
• It provides finance for start-ups- at their inception
or shortly after their first technical or commercial
developments
Venture Capital
Venture Capital Includes
• Seed: financing provided to fund research, assess and develop an
initial concept before a business has reached the start-up phase.
• Start-up companies: financing provided to companies for product
development and initial marketing. Companies may be in the process
of being set up or been in business for a short time, but have not sold
their product commercially.
• Early stage companies: financing to companies that have completed
the product development stage and require further funds to initiate
commercial manufacturing and sales. They will not yet be generating
a profit.
Expansion capital
• Expansion capital includes:
• Expansion (as such): financing provided for the growth and expansion
of an operating company, which may or may not be breaking even or
trading profitably. Capital may be used to finance increased
production capacity, marketing or product development.
• Bridge financing: financing made available to a company in the period
of transition from being privately owned to being publicly quoted.
• Rescue/Turnaround: financing made available to existing businesses,
which have experienced trading difficulties, with a view to re-
establishing prosperity.
Types of Private Equity

2/Growth capital
• Minority investments in established companies
• Strong growth characteristics
• Usually does not use leverage
• 100% equity
• 5+ years average investment life
Types of Private Equity

3/Mezzanine
• Elements of both debt and equity instruments
• Fixed returns from interest payments
• Opportunity to participate in capital appreciation
• Usually unsecured and subordinate to other obligations
• 2-3 years average investment life
Mezzanine Financing
Mezzanine Financing
Types of financial instrument: risk and reward
Types of Private Equity

Special situations
• Investments include distressed debt, infrastructure,
energy/utilities, and turnarounds
• Short investment cycle can produce high IRRs but
lower multiple on capital
• Average investment life varies
Distressed Debt
Weak Economy and Distressed Debt
Evolution of Distressed PE fund raising
Private Equity in Real Estate
PE in Clean Technologies
Private Equity in Infrastructure
Types of Private Equity

Buyout
• Control investments in established, cash-flow positive
companies
• Typically uses leverage
• Lower volatility of returns
• Debt & equity investments
• 4-5 year average investment life
Buy out
Buy out
LBO Steps
• An LBO typically involves the following three steps:
• The investors form a company (often a limited company) which
borrows the capital to acquire the shares in the target company; i.e.
the acquiring company is typically heavily financed by borrowed
capital.
• The investors acquire the target company.
• The target company is merged with the newly formed company.
Participants in a leveraged buy-out
MBO

A management buyout (MBO) is a transaction where a

company's management team purchases the assets and
operations of the business they manage.

A management buyout is appealing to

professional managers because of the greater potential rewards
and control from being owners of the business rather than
employees.
How are private equity funds structured? ‘Ten plus two’ funds
Typical private equity structure

Private Equity fund Mangers – General Partner

• –known as general partners (“GPs” or “managers”) form limited
partnership vehicles to invest in private companies

Investors
• commit a specified amount of capital(typically $10 million minimum)
to a private equity fund to become limited partners (“LPs”)
• GPs are also expected to invest their own capital alongside with LPs
Typical Private Equity structure

Typical private equity structure

What are LPs and GPs?
• The external investors are called limited partners (LPs) because their
total liability is limited to the amount they invest.
• The manager is often called the general partner (GP).
• The general partner has potentially unlimited liability for the actions
of the fund.
• To put a cap on this potentially unlimited liability many GPs are in fact
limited companies or partnerships.
• Technically, the fund manager invests in the general partner; however,
in common usage, LPs are investors and GPs are fund managers.
Who are the investors in private equity
funds?
• Private sector pension fund, Public pension fund,
• Funds of funds company
• Insurance company ,Endowment plan
• Banks and investment banks ,Investment company
• Government agency
• Corporate investor
• Private equity firm
• Sovereign wealth fund
• Wealth manager
Investee Companies – Portfolio of
Companies
What do private equity fund managers do?
1. Raise funds from investors
2. Source investment opportunities
3. Negotiate, structure and make investments
4. Actively manage investments
5. Realise returns
• 100 cr
• 200 cr nav
• 8% hurdle
• They will get
• Hurdle rate> Incentive for GP
• Hurdle rate used for paying
Typical private equity fund lifecycle
Private Placement Memorandum
Fund Raising and Investment Period
Low or Negative returns on PE during Initial Years
Committed versus invested capital
• It is important to understand that private equity funds do not
generally drawdown funds until they are needed.
• An investor makes a commitment to invest in the opportunities a fund
manager selects for the fund. They do not deposit the cash with the
fund manager.
• The GP fund manager has certainty of funds, but for the LP investor in
the fund this means that they have an uncertain cash commitment to
any particular fund, both in terms of timing of drawdown and the
total amount that will be drawn down
Illustrative investor cash flows
What risks do investors in private equity
funds take?
• In any equity investment, whether public or private, there is the risk
of losing the capital invested.
• In private equity, investments are long-term, irrevocable
commitments to fund unknown, future investment opportunities.
• An investor commits to these risks and delegates the investment
decision to the fund manager.
What risks do private equity fund managers
take themselves?
• To align the interests of investors and fund managers,
the fund managers typically invest alongside the
investors, on the same terms, in any fund.
• The fund manager is therefore both an investor, on the
same terms as other investors, and the fund manager
• If a fund loses money, the fund managers will make the
same loss on their investment offset by any income
guaranteed from fees not spent on the costs of the
fund.
What rewards do private equity investors
earn?
The fund manager has four sources of reward.
1. They may receive a return as an investor in the fund in the same
way as any other investor in the fund.
2. They receive a salary from the fund management company at a
normal market rate.
3. They may receive a share in the profits of the fund management
company.
4. They may receive something called ‘carried interest’ which is
triggered once a minimum threshold return is achieved.
About Management fees
What is carried interest?
• If the fund achieves returns above a minimum threshold, the fund
manager takes a preferential share of the return in the form of so-
called ‘carried interest’ (or ‘carry’).
• Traditionally the threshold, or hurdle rate, has been 8% per annum
over the life of the fund and the share has been 20% of the profits
above the hurdle rate
• Once the investors have achieved the hurdle rate, the fund
managers will share in the excess and usually this was 20% of any
excess.
• The hurdle rate (historically around 8% per annum but variable
from fund to fund) is calculated on the amounts actually invested.
The mechanics of carried interest
The mechanics of carried interest
Over the life of the fund, net income and capital distributions will be made in
the following order.
1. The GP receives a priority share of partnership returns each year.
2. The investors then receive a 100% return of commitments advanced and a
preferred rate of return (8%).
3. The carried interest holders receive 100% of all distributions until such time
that they have received 25% of the investors’ preferred return* (2 above). This is
referred to as ‘catch up’.
4. Thereafter the remaining distributions are split as follows:
• (a) 80% investors
• (b) 20% carried interest holders.
Performance Calculation - Waterfall
Waterfall – Step1
Waterfall – Step1 contd.
Catch-Up & Carry
European Waterfall vs US Waterfall
Claw Back ?
Escrow Account - New Concept in PE
Private Equity and Companies Life Cycle
What is leverage and what role does it play in
private equity?
• Using borrowed money alongside your own reduces the amount you
have to invest and so amplifies the returns or losses on any particular
investment.
• This amplification has various names: in the US it is called leverage, in
the UK it was traditionally called gearing.
• They are the same idea.
• When you use only your own money in an investment, the return on
the investment is the same as the return on your equity.
How big is the private equity market?
What are the largest private equity funds in the world?
CLAW BACK
• A clawback provision in a contract is a special clause included in
employment and financial contracts used for referring any money or
benefits which have been given out but are required to be returned due
to certain special circumstances that will be mentioned in the contract.
• Clawback provision permits the LP’s to “clawback” any carry forwarded
amount which was paid during the life of the fund on prior portfolio
investments in order to normalize the final carry to the originally agreed
percentage.
• Thus, the clawback provision prevents the LP’s from paying any
additional amount and then suffering a subsequent loss.
clawback provision

• A claw back provision ensures that the distribution of profits between

the GP and LPs is in line with the agreed profit split.
• For example, if the fund exits from a highly profitable investment
relatively early in its lifetime, but subsequent exits are less profitable,
the GP would be required by the clawback provision to return fees,
expenses and capital contributions to LPs so that the overall profit
sharing ratio conforms to the agreed profit split.
• Clawbacks are typically due on fund termination, but can sometimes
be reconciled annually
clawback provision

• A claw back provision ensures that the distribution of profits between

the GP and LPs is in line with the agreed profit split.
• For example, if the fund exits from a highly profitable investment
relatively early in its lifetime, but subsequent exits are less profitable,
the GP would be required by the clawback provision to return fees,
expenses and capital contributions to LPs so that the overall profit
sharing ratio conforms to the agreed profit split.
• Clawbacks are typically due on fund termination, but can sometimes
be reconciled annually
The Importance of a Clawback

• The clawback feature is detailed in the PPM and entitles investors to

get paid back any incentive fees taken by the manager during the life
of the investment.
• This is meant to protect investors in the event a manager takes an
incentive fee they should not have received.
• This clause is really only as good as the manager’s ability to pay it
back, though, so it’s important to invest with a manager who has a
strong balance sheet.
DEAL BY DEAL WATERFALLS
• Deal-by-dealwaterfalls,inwhichtheGPreceivescarriedinterestaftereach
individual deal.
• Deal-by-deal waterfalls result in earlier distributions to the GP.
TOTAL RETURN METHOD
• Total return method, in which carried interest is calculated on profits
earned by the entire portfolio. Total return waterfalls result in earlier
distributions to LPs. There are two alternatives under the total return
method.
• In the first alternative, the GP receives carried interest only after the
fund has returned the entire committed capital to LPs.
• In the second alternative, the GP receives carried interest on all
distributions once the value of the investment portfolio exceeds a
certain threshold above invested capital.
Catch-Up Clause

• Most private equity funds also have a catch-up clause that can be
found in the distribution section of the PPM.
• This clause is meant to make the manager whole so that their
incentive fee is a function of the total return and not solely on the
return in excess of the preferred return.
• For example, if the preferred return were 8% and the manager had a
20% performance fee subject to a catch up, the distributions would
flow as follows:
Catch-Up Clause
• This clause makes it so the manager receives 20% of the total profits if
the deal does well. To further illustrate, if the deal returns a 15%
annualized internal rate of return (IRR), the manager will receive 20%
of 15%, or 3% of total annualized profits.
• If a deal generates $5 million in profits and a 15% IRR, the manager
will receive a $1 million incentive fee.
• In the absence of a catch-up clause in this example, the manager
would only be entitled to 20% of the profits above the 8% preferred
return, which equates to 1.4% of annualized profits [.2 X (.15-.08)
=.014)].
Catch-Up Clause

• The investor would receive an annualized 8% preferred return and

their capital back.
• The manager would then receive 100% of distributions until they
receive 20% of all annualized profits (aka the catch up clause).
• All remaining dollars would be split on an 80%/20% basis, with the
majority going to investors.
• The investor is still protected in this situation because the manager is
not entitled to an incentive fee if the investment doesn’t meet the
hurdle of paying all of the capital back plus the 8% preferred return.
• In summary, waterfalls are all about how capital is distributed and can
either align or misalign interests.
• Making sure you are entering into the right fee structure is an easy
way to mitigate risk. All too often, deals are structured in favor of the
sponsor so it’s a ‘heads they win’ and ‘tails you lose’ situation.
• Waterfall structures can impact investment behavior and you want to
make sure the sponsor is motivated by the investment return. If the
deal doesn’t perform as planned, make sure the sponsor either
doesn’t take a performance fee or is subject to the clawback
provision.
• Getting into a structure where everyone’s interest are aligned from
day one is the key to successful investing.