Week 5 – Dr Jia (Lucy) Lu

Private Equity J.Lu@hw.ac.uk

At the end of this session, you should be able to:

 Understand and explain private equity and its importance;

 Compare and contrast venture capital firm, angel investor and

leveraged buyout;

 Discuss the characteristics of PE and its strategy; and

 Analyse the profit , valuation and exit options.

 Reading List:

 Harris, R.S., Jenkinson, T. and Kaplan, S.N. (2014) Private Equity Performance:
What Do We Know? The Journal of finance, 69 (5), pp. 1851-1882.

 Kaplan, S.N. and Schoar, A. (2005) Private Equity Performance: Returns,

Persistence and Capital Flows. The Journal of Finance, 60 (4), pp. 1791-1823.

 Lerner, J., Sorensen, M. and Stromberg, P. (2011) Private Equity and Long-run
Investment: The Case of Innovation. The Journal of finance, 66 (2). pp. 445-
477.
 Coverage

 Private Equity
 Business Model
 Characteristics of PE
 Profit & Valuation
 Exit
5.1 What is
PE
Watch the video HERE
 Private Equity
 Private Equity is an asset class consisting of equity securities in operating
companies that are not publicly traded on a stock exchange i.e. equity in
private companies.
 The use of pooled money to buy operating companies and later resell
them (part or whole).
 The Private Equity company itself may or may not be listed.
 And may invest in listed entities as well.
 A private equity investment will generally be made by a private equity firm, a
venture capital firm, an angel investor or a leveraged buyout.
 Often via a private equity fund
 Private Equity vs Venture Capital

https://www.slideshare.net/corporatebridge/private-equity-vs-venture-capital
Venture Capital Angel Investor

leveraged buyout
 Private Equity
 Each has own set of goals, preferences and investment strategies. Each
providing working capital to a target company to support:
 Expansion
 new product development
 restructuring (operations, management, or ownership)

 Much more secretive than listed companies

 Major benefit for owners is lack of transparency
 Excess is not as public

 Founders of successful PE firms come from listed companies (often which

failed).
 Private Equity Funds
Metrick and Yasuda (2010) define Private Equity Funds as:
1. A Private Equity Fund is a financial intermediary which takes investor’s
capital and invests in a portfolio.

2. It invests in private companies i.e. not traded on an exchange – usually

mature companies.

3. It is active in corporate governance and management.

4. It exits investments by sale or IPO.

5.2 Business
Model
 Strategy
 Generally, strategy is to:
 Buy businesses
 Add debt – often a lot of debt (2-1 ratio common)
 Leveraged buyouts
 Minimise tax
 Cut costs
 including facilities and employees
 Extract fees

 Often unpopular in press

 cut costs, job losses, social care, etc.

 And with investors sometimes:

 Big four (Apollo, Blackstone; Carlyle, KKR)
 Profits and Carried Interest
 Profit is often in the form of “carried interest”.
 Fee for enhancing performance – “performance
fee” – 80% for investors, 20% carried forward to
partners
 20% is common.
 Share of profits paid to fund manager.
 May also be a management fee of 1% or 2%.
 Known as: 2 and 20
What are the functions of ?

https://www.youtube.com/watch?v=tbRkdm80cFs
Source: https://www.youtube.com/watch?v=tbRkdm80cFs
Carlyle invested in Butterfield in March 2010 through Carlyle Global
Financial Services Partners.
 Carlyle sees significant
opportunity for private equity
across Asia

https://www.youtube.com/watch?
v=d4iUhjQGNeM

 Carlyle’s Rubenstein Expects

More Private Equity Deals in
2023

https://www.bloomberg.com/
news/articles/2023-01-20/
carlyle-s-rubenstein-expects-
more-private-equity-deals-in-
2023?leadSource=uverify
%20wall
 5.3
Characteristics of PE
DO PE funds target specific
companies?
 Established Distressed
Young Firms
Firms Firms
 Acquire
all shares Improve FP
PE Change
management exit

2 years +

Acquire
Hedge all shares
Funds exit

2 -3
months
 Illiquidity
 Sometimes liquidated and investors repaid.

 Firms can be wound down.

 Limited partners have “limited” access to their own money.

 To exit requires finding an investor who wants to buy in.

 No capital is removed from the fund.
 Why? Because money is often tied up in illiquid assets.
 Although dry powder is vast as well.
 Huge transactions cost of selling blocks (or even finding a buyer) –
likely to have to sell at a huge discount.
 Illiquidity
Comparison with Alternatives

 Withdrawal from:
 Banks – on demand
 Mutual funds – overnight
 Hedge funds – monthly, quarterly, annually or at worst bi-annually.

 Deposit insurance shields bank from panicky withdrawal.

 Bank runs
 Hedge funds can collapse quickly even if their investments may pay off
in the long term.
 PE can invest for the long term.
 Size and Stability
 But liquidity is the key to encouraging investment and success of market systems.

 Stability thus replaces liquidity.

 And stability provides scale.

 the significance of the funds they invest is huge:

 Blackstone – over 200 portfolio companies, half a million employees around
the world with $4.4 trillion.
 Carlyle – more than 18,000 PE funds with $369 billion assets as of 30 th
September 2022.
 KKR – 123 portfolio companies with $275 billion in annual revenues as of
30th June, 2022.
 Apollo – 2,153 employees (2021), and 92 billion as of 30th September 2022.
 Dry Powder

 Cash or marketable securities that are

low-risk and highly liquid and convertible
to cash

 Funds held as dry powder are kept in

reserve to be deployed in case of
emergency.

 For VCs, dry powder allows them to invest

in opportunities as they arise
 Dry Powder
Dry powder means the capital committed but not yet invested, reaches
record high in 2020.

Global private equity dry powder is at a record level of nearly $2 trillion with
25% in Asia-Pacific and another 19% in Europe.

PE can truly “do well by doing good” with its unique contribution to ESG and
impact investing.

Dry powder allocated to Asia Pacific continues to outgrow US, Europe,

Middle East and Africa popularly known as the EMEA region) in 2021 as
institutional investors continue to increase allocations toward Asian PE/VC
firms, according to KPMG
Global Private Equity Dry Powder reaches high record in 2020

Source: Wealth and Society, 2023

The trend of ESG going mainstream is
unstoppable for private equity
The Covid 19 pandemic has reinforced investors’
awareness for long-term business sustainability, as
well as financial performance.

ESG indicators and ESG investment analysis is now a

part of the due diligence process.

PE firms today are active investors, rather than

passive financiers who are also offering guidance to
build a strong company.

PE firms often have a long investment horizon, the

holding periods until exits can last from five to seven
years. PE firms therefore have a unique advantage to
do well by making impactful investment.
Source: Wealth and Society, 2023
 5.4
Profit & Valuation
 Valuation
 Portfolio of Private Equity company is made up of private companies of
which little information is available publicly.

 Information asymmetry between fund and companies is thought to be

greater than for listed companies.

 Valuation is difficult as no market price so value only clear at end of

funds lifetime.
 Investors locked in for long periods, 10 years common
 Valuation
 In a typical leveraged buyout transaction, a private equity firm buys
majority control of an existing or mature firm.
 Seek exit when market conditions favourable.

 This is distinct from a venture capital or growth capital investment, in

which the investors (typically venture capital firms or angel investors)
invest in young or emerging companies, and rarely obtain majority
control.
 Valuing Targets
 Private targets - the usual methods:
 Tobin’s Q
 MBR (Market to Book ratio)
 P/E ratio valuation
 Relative Valuation
 Discounted Cash Flow Valuation

• Public targets:
 Due diligence
 Market price for listed companies.
 Check against benchmarks such as P/E ratio and TQ.
 Maybe bid up to expected value.
Source: Private Equity International, 2022
Source: Private Equity International, 2022
5.5 EXIT
 Exit

 Exit requirement is a distinguishing feature of Private Equity investments.

 No need to worry about synergy or strategy (with their own
portfolio).
 Unlike mutual or hedge funds, Private Equity is illiquid. Hard to exit.
Locked in?
 Need a clear exit strategy and funds have a finite lifetime e.g. 10
years and a fixed fund size. Investors can’t exit until closure.
 Funds get rolled over when exit is difficult.
 Exit
 Mechanisms to return money to investors:

 Often via an IPO – timing may be important.

 Stake of Private Equity company may be sold at IPO or shortly
after in the open market.

 Sale to another investor (e.g. another buyout fund) or another

company (acquisition). Known as a ‘trade sale’.
Source: S&P Global Market Intelligence, 2023
Months of macroeconomic turmoil and rising
recession risk put global private equity exit
value on track to fall by nearly one-third in
2022 compared to 2021's record year.

Private equity-backed IPOs slowed to a trickle

in 2022, totalling 52 globally and raising an
aggregate $23.71 billion. By comparison, there
were nearly four times as many private equity-
backed IPOs in 2021 — a total of 196 globally.

The aggregate value of private equity exits

globally came in at $391.44 billion for the year,
down 32.1% from the 2021 total, according to
private markets data source Preqin Pro.

Source: S&P Global Market Intelligence, 2023

 Class Discussion

How is Investment banking

(underwriter) different from PE?
Thanks for Your
Attention
Week 6 – Consolidation Week –
NO Lecture