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- Sprache: Englisch
A step-by-step, comprehensive approach to private equity and private debt
Private Capital Investing: The Handbook of Private Debt and Private Equity is a practical manual on investing in the two of the most common alternative asset classes (private equity and private debt) and provides a unique insight on how principal investors analyze investment opportunities. Unlike other textbooks available in the market, Private Capital Investing covers the various phases that principal investors follow when analyzing a private investment opportunity.
The book combines academic rigor with the practical approach used by leading institutional investors. Chapters are filled with practical examples, Excel workbooks (downloadable from the book website), examples of legal clauses and contracts, and Q&A. Cases are referred at the end of every chapter to test the learning of the reader. Instructors will find referrals to both third-party cases or cases written by the author.
• Covers analytical tools
• Includes the most common methods used to structure a debt facility and a private equity transaction
• Looks at the main legal aspects of a transaction
• Walks readers through the different phases of a transaction from origination to closing
Bridging the gap between academic study and practical application, Private Capital Investing enables the reader to be able to start working in private equity or private debt without the need for any further training. It is intended for undergraduates and MBA students, practitioners in the investment banking, consulting and private equity business with prior academic background in corporate finance and accounting.
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Table of Contents
Cover
About the Author
Acknowledgements
About the Companion Site
Introduction
THE RISE OF PRIVATE MARKETS (ALTERNATIVE ASSETS) IN THE INVESTORS' ALLOCATION
THE RISE OF PRIVATE MARKETS AS A FAVOURED ALTERNATIVE SOURCE OF COMPANY FINANCING
PRIVATE EQUITY
PRIVATE DEBT
DEAL PHASES AND BOOK ORGANISATION
NOTE
CHAPTER 1: Closed End Funds
A CLOSE UP ON PRIVATE EQUITY AND PRIVATE DEBT PARTNERSHIPS
CASH FLOWS, J CURVE, AND RETURNS
FINANCIAL RETURNS
REFERENCES AND FURTHER READING
SUGGESTED CASES
NOTES
CHAPTER 2: Debt Products
INTRODUCTION
DEFINITION AND SOME USEFUL CLASSIFICATIONS
PURE DEBT INSTRUMENTS
HIGH-YIELD BONDS
MEZZANINE
UNITRANCHE
A CLOSE UP ON SYNDICATED LENDING
REFERENCES AND FURTHER READING
SUGGESTED CASES
CHAPTER 3: Equity Products
INTRODUCTION
ORDINARY SHARES
PREFERENCE SHARES
CONVERTIBLES
OTHER EQUITY INSTRUMENTS
REFERENCES AND FURTHER READING
SUGGESTED CASES
NOTES
CHAPTER 4: Business Due Diligence
INTRODUCTION
MACRO FACTORS
INDUSTRY RISK ANALYSIS
COMPANY ANALYSIS
SUMMARY STEPS FOR A STRATEGIC ANALYSIS OF A BUSINESS PLAN
REFERENCES AND FURTHER READING
SUGGESTED CASES
NOTES
CHAPTER 5: Accounting Due Diligence
INTRODUCTION
QUALITY OF EARNINGS
RATIO ANALYSIS
CASH FLOW ANALYSIS
CREATIVE ACCOUNTING
REFERENCES AND FURTHER READING
SUGGESTED CASES
NOTES
CHAPTER 6: Business Plan
INTRODUCTION
PRO-FORMA FINANCIALS
PROFIT AND LOSS PROJECTIONS
BALANCE SHEET PROJECTIONS
PUTTING IT ALL TOGETHER: MODELLING CASH, SHORT-TERM DEBT, NET INCOME, AND SHAREHOLDERS' EQUITY
SENSITIVITY ANALYSIS
CONSISTENCY CHECKS
REFERENCES AND FURTHER READING
SUGGESTED CASES
CHAPTER 7: Valuation
INTRODUCTION
FUNDAMENTALS #1: PRICE AND VALUE
FUNDAMENTALS #2: ENTERPRISE VALUE AND EQUITY VALUE
FUNDAMENTALS #3: MARKET VALUES VS. BOOK VALUES
DISCOUNTED CASH VALUATION METHOD
DISCOUNTED CASH VALUATION: WACC APPROACH
DISCOUNTED CASH FLOW VALUATION: ADJUSTER PRESENT VALUE METHOD
COMPARABLES VALUATION METHOD
REFERENCES AND FURTHER READING
SUGGESTED CASES
NOTES
CHAPTER 8: Growth Equity
INTRODUCTION
DIFFERENCES BETWEEN VENTURE CAPITAL, GROWTH EQUITY, AND LBO
INSTRUMENTS
FUNDAMENTALS #1: PRE-MONEY AND POST-MONEY VALUATION
FUNDAMENTALS #2: CAPITALISATION TABLE
FUNDAMENTALS #3: DILUTION AND EQUITY STAKE CALCULATION
FUNDAMENTALS #4: ANTI-DILUTION PROVISIONS
FUNDAMENTALS #5: STRUCTURING FOR EXIT (ORDINARY SHARES VS. OTHER INSTRUMENTS)
FUNDAMENTALS #6: REDEMPTION
FUNDAMENTALS #7: THE GROWTH CAPITAL METHOD (ADAPTED FROM THE VENTURE CAPITAL METHOD)
FUNDAMENTALS #8: CALCULATION OF THE PRICE PER SHARE
FUNDAMENTALS #9: PUT AND CALL OPTIONS
REFERENCES AND FURTHER READING
SUGGESTED CASES
NOTE
CHAPTER 9: Leveraged Buyout
INTRODUCTION
LBO: KEY CONCEPTS
LBO ANALYSIS
REFERENCES AND FURTHER READING
SUGGESTED CASES
NOTES
CHAPTER 10: Management of the Portfolio Companies and Exit
INTRODUCTION
REPORTING
MONITORING
VALUE CREATION
EXIT
IPO
TRADE SALE
SECONDARY/TERTIARY SALE TO FINANCIAL BUYERS
OTHER EXIT ROUTES (SHARE BUYBACK, OPTIONS, RECAP)
REFERENCES AND FURTHER READING
SUGGESTED CASES
CHAPTER 11: Private Debt
INTRODUCTION
STRUCTURING A CREDIT FACILITY
SANITY CHECKS
STRUCTURING A LOAN FACILITY: A MODELLING EXAMPLE
REFERENCES AND FURTHER READING
SUGGESTED CASES
NOTE
CHAPTER 12: Legal Documentation
INTRODUCTION
PRIVATE DEBT LEGAL DOCUMENTATION
PRIVATE EQUITY LEGAL DOCUMENTATION
REFERENCES AND FURTHER READING
APPENDIX 12.1: EXAMPLE OF AN EQUITY TERM SHEET
APPENDIX 12.2: EXAMPLE OF A DEBT TERM SHEET
CHAPTER 13: Distress Symptoms and Remedies
EARLY WARNING SIGNALS
CAUSES
RESTRUCTURING OPTIONS
FINANCING SOLUTIONS
LEGAL ALTERNATIVES
REFERENCES AND FURTHER READING
SUGGESTED CASES
Index
End User License Agreement
List of Tables
Introduction
TABLE I.1 Different types of private equity as a function of the investee compan...
TABLE I.2 The Required IRR as a function of investee company life cycle.
TABLE I.3 Different types of private debt as a function of the investee company ...
TABLE I.4 Required IRR as a function of debt product / fund.
Chapter 1
TABLE 1.1 IRR (%) as a function of time and cash on cash exit multiple.
TABLE 1.2 Cash on cash (X) exit multiple calculated as a function of time and IR...
TABLE 1.3 Target return as a function of instrument.
TABLE 1.4 Target return as a function of the company stage.
Chapter 2
TABLE 2.1 Key differences between different banking products.
TABLE 2.2 Key differences between different banking products.
TABLE 2.3 Key differences between European and US mezzanines.
TABLE 2.4 Key differences among senior, mezzanine, high-yield, and unitranche.
Chapter 3
TABLE 3.1 Key differences among preferred shares.
Chapter 5
TABLE 5.1 Cash flow statement.
TABLE 5.2 Additions and deductions of key non-cash expense and income.
TABLE 5.3 Additions and deductions for non-operating gains and losses.
TABLE 5.4 Additions and deductions for changes in operating-related assets and l...
TABLE 5.5 Operating cash flow.
TABLE 5.6 Key items classified as investing cash sources or uses.
TABLE 5.7 Key items classified as financing inflows and outflows.
TABLE 5.8 A guide to obtaining sustainable cash flow.
TABLE 5.9 Creative accounting tricks by level of intensity.
TABLE 5.10 Documents for analysis.
TABLE 5.11 Summary of asset types and related reserve accounts.
Chapter 7
TABLE 7.1 Comparison of the most used multiples.
Chapter 8
TABLE 8.1 Differences between venture capital and growth equity.
TABLE 8.2 Key differences between growth equity and LBO.
TABLE 8.3 Key differences between venture capital, growth equity, and LBO.
TABLE 8.4 Example of a capitalisation table with no price dilution.
TABLE 8.5 Example of capitalisation table with option pool (issue option with no...
TABLE 8.6 Example of a capitalisation table with different share prices and step...
TABLE 8.7 Initial ownership structure with two shareholders and two instruments.
TABLE 8.8 Ownership situation with full ratchet of one investor and entry of a s...
TABLE 8.9 Ownership situation with weighted ratchet of one investor and entry of...
TABLE 8.10 Exit example in presence of private equity fund owning ordinary share...
TABLE 8.11 Exit example in presence of private equity fund owning convertible pr...
TABLE 8.12 Exit example in presence of private equity fund owning participating ...
TABLE 8.13 Exit example in presence of private equity fund owning, participating...
TABLE 8.14 Growth capital method with one financing round.
Chapter 9
TABLE 9.1 Sources and uses table of an LBO.
TABLE 9.2 A typical LBO capital structure.
TABLE 9.3 Comparison of different debt products used in an LBO.
TABLE 9.4 Three alternative leveraged recapitalisation structures.
TABLE 9.5 Value creation in an LBO with the same entry and exit values but diffe...
TABLE 9.6 Summary output of an LBO model.
TABLE 9.7 Summary credit statistics of an LBO.
TABLE 9.8 LBO equity returns.
Chapter 11
TABLE 11.1 Typical lending margins in asset-based lending transactions.
TABLE 11.2 Credit risk as a function of business, financial, and liquidity risk.
Chapter 13
TABLE 13.1 Restructuring options as a function of its causes.
TABLE 13.2 Debt trading levels and potential solutions.
List of Illustrations
Introduction
FIGURE I.1 Private market assets under management in 2018.
FIGURE I.2 Private market assets under management by region and by asset cla...
FIGURE I.3 Banking system assets as a percentage of GDP.
FIGURE I.4 Share of banking system assets in total financial institution ass...
FIGURE I.5 Number of listed companies by region.
FIGURE I.6 Private equity AUM by region and type (in US$).
FIGURE I.7 Private debt AUM by region and type (in US$).
Chapter 1
FIGURE 1.1 A typical private equity (debt) fund structure.
FIGURE 1.2 Timeline of private equity (debt) fund.
FIGURE 1.3 J-curve effect in a private equity (debt) fund.
Chapter 2
FIGURE 2.1 Comparison of rating categories per rating agency.
FIGURE 2.2 Some modelling examples of debt products.
Chapter 3
FIGURE 3.1 Convertible fundamentals.
FIGURE 3.2 Example of a convertible security.
FIGURE 3.3 Some modelling examples of equity products.
Chapter 4
FIGURE 4.1 Porter Five Forces model.
FIGURE 4.2 Porter's industry value chain.
FIGURE 4.3 Boston Consulting Group Matrix.
Chapter 5
FIGURE 5.1 General key areas of attention in accounting due diligence.
FIGURE 5.2 Profit and loss key areas of attention in accounting due diligenc...
FIGURE 5.3 Balance sheet key areas of attention in accounting due diligence.
FIGURE 5.4 The effect of some accounting policies on balance sheet and net i...
Chapter 6
FIGURE 6.1 A modelling example of a business plan.
Chapter 7
FIGURE 7.1 From equity value to enterprise value.
FIGURE 7.2 Steps in a DCF valuation.
FIGURE 7.3 Valuation methodologies: a modelling example.
Chapter 8
FIGURE 8.1 Products used by private capital funds in deal structuring.
FIGURE 8.2 Example of two investors with a call option at the same valuation...
FIGURE 8.3 Growth equity structuring: a modelling example.
Chapter 9
FIGURE 9.1a Determination of equity value starting from purchase price.
FIGURE 9.1b Determination of equity value starting from share price.
FIGURE 9.2 Sources and uses of an LBO.
FIGURE 9.3 Summary table of key economic features of an LBO.
FIGURE 9.4 LBO structuring: a modelling example.
Chapter 11
FIGURE 11.1a Contractual subordination example.
FIGURE 11.1b Structural subordination.
FIGURE 11.2 Modelling example of a private debt transaction.
Guide
Cover
Table of Contents
Begin Reading
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Private Capital Investing
The Handbook of Private Debt and Private Equity
ROBERTO IPPOLITO
This edition first published 2020
© 2020 John Wiley & Sons Ltd.
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Library of Congress Cataloging-in-Publication Data
Names: Ippolito, Roberto, 1969- author.
Title: Private capital investing : the handbook of private debt and private equity / Roberto Ippolito.
Description: Chichester, West Sussex, United Kingdom : John Wiley & Sons, 2020. | Series: The Wiley finance | Includes bibliographical references and index.
Identifiers: LCCN 2019033206 (print) | LCCN 2019033207 (ebook) | ISBN 9781119526162 (hardback) | ISBN 9781119526131 (adobe pdf) | ISBN 9781119526193 (epub)
Subjects: LCSH: Private equity. | Investments. | Capital market.
Classification: LCC HG4751 .I67 2020 (print) | LCC HG4751 (ebook) | DDC 332.6—dc23
LC record available at https://lccn.loc.gov/2019033206
LC ebook record available at https://lccn.loc.gov/2019033207
Cover Design: Wiley
Cover Images: © Classen Rafael/EyeEm/Getty Images, © tifonimages/Getty Images
To Gaia
About the Author
Roberto Ippolito is Managing Partner of a leading hybrid capital (private equity and private debt) fund and Professor of Principal Investing at Università degli Studi Guglielmo Marconi.
Roberto has 20 years' private capital experience in sourcing, structuring, and investing in all parts of the capital structure (senior debt, junior debt, and private equity) of Italian SMEs across several industries and three years' management consulting experience (with a focus on business due diligence and performance improvement).
Former Head of Leverage Finance at General Electric Capital Italy, Roberto has held managerial roles at European Bank for Reconstruction and Development, DAM Capital (Anschutz Group), Bain & Co. He also held junior positions at Goldman Sachs (Merchant and Investment Banking) and Istituto Mobiliare Italiano (Merchant Banking).
Roberto is a Fulbright Scholar and a British Chevening Scholar. He has written academic and popular articles and books on economics and finance (with a focus on private equity and private debt) and teaches various Executive courses and Masters at the London Stock Exchange Academy and 24Ore Business School.
Roberto received an MBA from the University of Chicago, an MSc in Economics from the University of Warwick and a Summa Cum Laude BSc in Business from LUISS University. He is a CFA and CPA in Italy and FSA registered in the UK.
Acknowledgements
Writing a book on topics which have been the basis of 20 years of work is – to use Steve Jobs's words – to ‘connect the dots looking backwards’. In this connection of points, there are many people who have accompanied me and to whom I owe a thanks. As always, it is easy to forget someone: in this sense, I apologise in advance to the many I have omitted or forgotten.
The first thanks goes to my parents and my grandparents who – with sacrifices and example – taught me the importance of education and work ethic.
Among the different universities where I have developed my knowledge, I will be eternally grateful to the University of Chicago Booth School of Business, the cradle of breakthrough finance ideas and Nobel prizes. Every professor of my MBA has contributed to my knowledge, but I would like to specially thank – in strict alphabetical order – Professor Eugene F. Fama, Steven Neil Kaplan, Scott F. Meadow, James E. Schrager, Pietro Veronesi, Robert W. Vishny, and Luigi Zingales.
Several university professors have taught me lifelong lessons: amongst all of them, I want to thank Luigi Zingales of the University of Chicago for opening my horizons to the knowledge of private equity in the United States and Marcus H. Miller of the University of Warwick for suggesting I protect the 20% of the time devoted to reasoning in everyday work (the remaining 80% being pure execution).
I had the honour of working for prestigious institutions and outstanding professionals: amongst all these I want to remember Robert Wardrop (DAM Capital, University of Cambridge) for sharing the sharpness and ‘long’ view in the difficult investment decisions in mezzanine finance, James Fenner (GE Capital) for giving an international imprinting to my knowledge of leverage finance, and Rainer Masera (IMI, Intesa Sanpaolo) whose intellectual rigour I have tried to aspire to – not only in private equity.
I have also met brilliant individuals on various deals, whose wisdom pills have enriched my professional career: of all these, I would like to mention with gratitude Luca Bassi (Bain Capital), Luigi Bartone (ICG), Luca Peyrano (London Stock Exchange and Elite), and Giuseppe Castagna (BancoBPM).
A warm thanks goes also to the investors, employers, and colleagues of the various investment initiatives (private equity and private debt funds, investment vehicles, banks) where I have developed and applied my knowledge.
I would like to thank my longtime friend Simone Strocchi, founder and managing partner of Electa, adviser in deal structuring activities for private equity and private debt funds and pioneer of innovative solutions to help the listing of successful Italian SMEs. A warm thanks to Luca Magliano, who has worked with me at GE Capital and is now Manager at Electa, who has provided invaluable modelling assistance for this book.
A warm thanks to Alessandro Bonazzi, associate at Simmons & Simmons, who has provided substantial support in the drafting and review of the chapter on legal aspects of private equity and private debt transactions. I would like to also thank my longtime friend Andrea Accornero, managing partner of Simmons & Simmons, a leading international law firm (with offices in the EU, Asia, and the Middle East) with a sector focus in asset management and investment funds and financial institutions among others.
A special thanks to all the Wiley team who supported me in this journey: Gemma Valler for her utmost professionalism and firm steering, Benjamin Elisha and Koushika Ramesh for their support and patience, Gladys Ganaden for her guidance and help, and the production editor.
Finally, the most heartfelt thanks:
To Ilaria for the support and for the patience to tolerate all the times I had to say ‘sorry, I'll call you back later, I'm busy now’.
To Gaia who gave significance to my life and to whom I owe my biggest apologies for my absence in her daily life. To her, my sweetest and loving wishes of a life full of happiness, health, and success.
About the Companion Site
This book is accompanied by a companion website:
www.wiley.com/go/privatedebtprivateequity
The website includes the following materials for instructors (password: Ippolito2019) and students (open access):
Instructors:
Test Bank
PowerPoints
Students:
Excel Spreadsheets.
Introduction
The alternative investment industry has grown from $1 trillion in 1999 to nearly $6 trillion in 2018 (source: PreQin) and is expected to more than double to $15 trillion by 2022 (source: PWC AWM Research Center analysis). Within the various alternative asset classes, private debt and private equity already represent a significant share and are expected to grow faster than other asset classes.
The main drivers of growth are represented, on the supply side, by regulatory changes (constraining bank lending). On the demand side, small and mid size companies find it increasingly interesting to be financed by principal investors (alternative lenders and private equity funds) which are not only mere providers of specialised capital but – from due diligence to monitoring and value creation – also support entrepreneurs in their strategic, business and financial decisions.
Alternative assets classes are also an appealing investment opportunity for institutional investors because they offer both income and capital appreciation.
These dramatic changes in the financial landscape have been only partially accompanied by adequate educational tools: no handbook on private debt is available, whilst private equity textbooks take a very partial view (the financial analysis one) of investment decisions.
The book Private Capital Investing. Handbook of Private Debt and Private Equity (henceforth Private Capital Investing) is a practical handbook on investing in the most common alternative asset classes and provides a unique insight into how principal investors analyse investment opportunities.
Unlike other textbooks available in the market, the book covers the various phases that principal investors follow when analysing a private investment opportunity. Private Capital Investing combines academic rigour with the practical approach used by leading investors. Every chapter is filled with practical examples, Excel workbooks (downloadable on the book companion website), and examples of legal clauses and contracts. Further reading and cases are suggested at the end of every chapter to guide further in-depth analysis and test the learning of the reader.
Purpose of the book is to build a bridge between study and real-life case studies so that the reader will be able to start working in the principal investing world without need for further training. It is intended for undergraduates and MBA students, practitioners in investment banking, consulting, private debt, and private equity business with prior academic background in corporate finance and accounting.
THE RISE OF PRIVATE MARKETS (ALTERNATIVE ASSETS) IN THE INVESTORS' ALLOCATION
The key reasons for allocating to private markets are:
Potential for alpha:
one of the main reasons to invest in alternative assets is to earn a premium (i.e. alpha) over the return offered by public market assets. There are at least three sources of alpha:
illiquidity premium: premium paid to the investor to compensate them for not having short-term access to their money, hence making private capital asset classes suited for investors with a longer time horizon (also called patient capital);
active premium: this derives from the active management of the private investment;
complexity premium: origination, structuring, and managing private assets is one of the key features and challenges of private capital investing.
Diversification:
alternative investments lack correlation with the major traditional asset classes of public equities and public fixed-income assets. Risk within the asset classes can be further diversified by geography, industry/sector, and capital structure (equity, senior debt, junior debt).
The private markets space is varied and hard to define in its entirety: according to McKinsey (see Figure I.1), private market assets under management (AUM) in 2018 totalled $5.8 trillion. Out of total AUM, private equity, growth equity, and private debt represent 54%.
FIGURE I.1 Private market assets under management in 2018.
Source: ‘Private markets come of age’, February 2019, McKinsey & Company, www.mckinsey.com. (c) 2019 McKinsey & Company. All rights reserved. Reproduced with permission.
Figure I.2 breaks down AUM by asset class and by region. In all regions, private equity commands the bulk of AUM, with real estate and private debt funds competing for the second place. The USA has by far the largest AUM, with China growing at the fastest pace.
FIGURE I.2 Private market assets under management by region and by asset class in 2018 (US$ bn).
Source: © 2018, CFA Institute. Reproduced and republished from Capital Formation: The Evolving Role of Public and Private Markets with permission from CFA Institute. All rights reserved.
THE RISE OF PRIVATE MARKETS AS A FAVOURED ALTERNATIVE SOURCE OF COMPANY FINANCING
Private markets have also become a favoured funding alternative for corporates following the structural changes that have occurred in both debt and equity markets.
In the debt market, after the financial crisis of 2008, different regulatory directives (Dodd–Frank, Volcker rule, Basel III) have been introduced in order to reduce the probability of bank insolvency. These regulatory requirements have forced banks to reduce their exposure to small and mid caps and also diminish the size of their asset book. This reduction has been particularly evident in Europe, as shown in Figure I.3, where c. 80% of corporate financing is still provided by bank loans (with the remaining 20% provided by capital markets and credit funds). This 80/20 split is the exact opposite in the US, where markets provide the majority of corporate financing. Bank disintermediation in fact started in the US in the early 1960s, when the provisions set forth by the Glass–Steagall Act in 1933 were gradually eased, allowing for a quick development of the high-yield market and of private debt (whose size, as we have seen before, is ten times larger than the European one).
Increased competition from other intermediation channels has caused the banking system's share of total financial institution assets to decline, as shown in Figure I.4.
FIGURE I.3 Banking system assets as a percentage of GDP.
Source: Reproduced from Bank for International Settlements. Structural changes in banking after the crisis. CGFS Papers No 60, 2018.
FIGURE I.4 Share of banking system assets in total financial institution assets.
Source: Reproduced from Bank for International Settlements. Structural changes in banking after the crisis. CGFS Papers No 60, 2018.
In the equity market, according to a study of the Miken Institute,1 in the US there are more firms owned by private equity investors than are listed on all the US stock exchanges.
Statistics on listed (see Figure I.5) companies similarly confirm that around the world (with the only exception of China) the appeal of public markets has stalled or diminished.
There are different explanations for this trend:
Reduced short-term pressure:
public markets are often blamed for the excessive focus on short-term financial goals.
Regulatory disclosure and reporting requirements:
being listed implies compliance with regulatory rules and continuous communication with the market.
Flexibility and speed to execute changes in strategy and operations:
operating in a private context allows owners and managers to swiftly implement changes in strategies, personnel, and operations without the need to explain and convince the market.
Increasing relative importance of institutional investors vs. retail investors:
the growing importance of institutional investors allows companies to raise funds without all the requirements necessary for publicly traded companies with retail investors.
FIGURE I.5 Number of listed companies by region.
Source: © 2018, CFA Institute. Reproduced and republished from Capital Formation: The Evolving Role of Public and Private Markets with permission from CFA Institute. All rights reserved.
Amongst alternative investments, this book will focus on two of the most popular asset classes: private equity and private debt.
PRIVATE EQUITY
Private equity is the investment activity by institutional investors in the equity capital of non-listed companies, with the goal of increasing their equity value in order to divest it within the medium/long term. Financial scholars describe private equity as a function of the different life stages of a company, as shown in Table I.1.
Venture capital can be further divided into the following.
Seed financing:
investment in risk capital when there is no product at all, when the entrepreneur only has an idea or an invention.
TABLE I.1 Different types of private equity as a function of the investee company life cycle.
Life stage
Type of private equity
Start-up
Venture capital (early-stage financing)
Development
Growth equity (development or expansion capital)
Maturity
Leveraged buy out (replacement capital)
Restructuring
Distressed equity
Start-up financing:
the investor intervenes in the start-up phase of production, while not knowing yet the commercial validity of the product or service. Compared with the previous phase, there is a prototype (i.e., the so-called phase of experimentation has been completed). There is a company and management that has already started appropriate market research and product testing.
First-stage financing:
intervention in the phase following the start-up of the production activity, where the commercial validity of the product has yet to be evaluated concretely.
Growth equity is aimed at supporting development plans via organic growth (e.g. the launch of new products or penetration into new markets) or via external lines (e.g. through acquisitions) through the subscription of a capital increase or a convertible bond/loan. It generally consists of a minority stake in the company.
Leveraged buy out consists of the acquisition of a majority stake financed by a mix of equity and third-party debt.
Investors require different returns from investing in private equity as a result of the different levels of risk, as shown in Table I.2.
Figure I.6 illustrates the breakdown of private equity AUM by region and by private equity type.
TABLE I.2 The Required IRR as a function of investee company life cycle.
Type of private equity
Required internal rate of return (IRR) (%)
Start-up
>40
Distressed equity
>35
Expansion capital
>25
Leveraged buy out
>20
Quasi equity (mezzanine)
15–20
Portage and equity dressed debt
10–15
FIGURE I.6 Private equity AUM by region and type (in US$).
Source: © 2018, CFA Institute. Reproduced and republished from Capital Formation: The Evolving Role of Public and Private Markets with permission from CFA Institute. All rights reserved.
PRIVATE DEBT
Private debt is the financing activity by institutional investors in non-listed companies, with the goal of maximising investors' returns though a combination of fees and interest charges (and eventually capital gains). Financial scholars describe private debt as a function of the different life stages of a company, as shown in Table I.3.
A more granular definition distinguishes between:
Private debt:
financing by private debt funds of transactions (leveraged buy outs or LBOs) where the shareholder is a private equity fund.
TABLE I.3 Different types of private debt as a function of the investee company life cycle.
Life stage
Type of private debt
Start-up
Venture debt (early-stage financing)
Development
Growth debt (development or expansion capital)
Restructuring
Distressed debt
Direct lending:
financing by private debt funds of SMEs. The use of proceeds is generally aimed at supporting growth (internal or external).
Figure I.7 illustrates the breakdown of private debt AUM by region and by private debt type.
FIGURE I.7 Private debt AUM by region and type (in US$).
Source: © 2018, CFA Institute. Reproduced and republished from Capital Formation: The Evolving Role of Public and Private Markets with permission from CFA Institute. All rights reserved.
TABLE I.4 Required IRR as a function of debt product / fund.
Type of private debt fund
Required IRR (%)
Senior debt unlevered funds
4–6
Senior debt levered funds
6–8
Leveraged buy out funds
5–7
Mezzanine funds
8–12
Hybrid capital funds
10–15
Distressed credit funds
15–18
From an investor perspective, private credit strategies can be categorised as:
Capital preservation:
these strategies, like traditional sponsor-focused debt funds, seek to deliver predictable returns whilst protecting against losses. Returns arise primarily from cash pay coupons, pay in kind (PIK) interest, and fees, whilst equity style returns are generally absent. Loss mitigation is essential since the possibility of gains is limited or absent. From a product perspective, capital preservation strategies include senior and mezzanine funds.
Return-maximising:
these strategies, like hybrid capital and distressed corporate credit funds, focus on capital appreciation through a combination of income and equity style returns. Whilst distressed credit investors seek to generate private equity-like returns, buying discounted loans or bonds in the expectation of a par refinancing or a return-enhancing negotiated settlement, hybrid capital funds seek capital appreciation by using a mix of debt and equity as an alternative to dilutive private equity. From a product perspective, return-maximising strategies include senior (for distressed credit funds), debt, and preferred equity (for hybrid capital) funds.
Investors require different returns from investing in private debt as a result of the different levels of risk, as shown in Table I.4.
DEAL PHASES AND BOOK ORGANISATION
Private equity and private debt funds, providing medium to long-term finance against cash flows, use a similar methodology and approach. The typical phases of a deal are:
Origination:
phase of finding an opportunity. This usually happens through a proprietary network of contacts, a joint venture with banks, auditors, etc.
Signing of a non-disclosure agremeent:
signature of this document allows the fund to have access to confidential information on the target company (the ‘Target’).
Preliminary analysis of the opportunity:
analysis based on available information on market opportunity, company positioning, historical financials, and the business plan of the Target.
Valuation
(if private equity deal): indicative valuation of the Target.
Deal structuring:
based on the analysis of the Target, alternative deal structures are prepared to meet the Target's needs and the fund's return objectives.
Letter of interest and exclusivity:
formulation of a proposal, outlining key terms and conditions of the deal.
Due diligence:
accounting, tax, business, environmental, and legal in-depth analysis are usually outsourced by the fund to a team of external experts.
Legal documentation:
set of legal documents that are needed to close the transaction.
The book is organised as follows.
The first section of the book covers the fundamentals. Chapter 1 analyses structure, economics, and the expected returns of closed end funds (the typical structure of private equity and private debt funds). Chapter 2 shows the key features of pure debt (banking and capital market) products, mezzanine, high-yield, and unitranche and provides some Excel modelling examples of debt products. Chapter 3 offers an overview of (ordinary and preferred) equity, various types of convertibles, options, and warrants and finally provides some Excel modelling examples of equity products.
The second section covers the preliminary analysis. Chapter 4 deals with business due diligence, analysing the market dynamics, competition, and positioning of the Target in order to obtain a critical view of all the ‘business’ aspects that affect the capacity of the Target to be profitable and to produce cash in the long term. Chapter 5 focuses on accounting due diligence and reviews quality of earnings, accounting policies, and adjustments (with particular reference to earnings before interest, tax, depreciation, and amortisation (EBITDA) and net financial position) to obtain ‘normalised’ (net of non-recurring items, accounting policies, etc.) figures; an analysis of cash flows and key ratios completes the accounting analysis. Chapter 6 offers a concise outline of key steps in financial projection with reference to the construction of pro-forma financials and sensitivity analysis; a simplified Excel model of building a business plan is presented. Chapter 7 (applicable to equity deals only) presents the most used valuation methods: discounted cash flow, adjusted present value, market multiples, and transaction multiples; the chapter ends with an Excel modelling example of the valuation of a company using the abovementioned different methodologies.
The third section focuses on deal structuring. Chapter 8 explains some fundamental concepts (pre-money and post-money, capitalisation table, equity stake calculation, dilution, anti-dilution provisions, growth capital method) and, in an Excel modelling example, analyses how to structure a growth (minority) equity transaction.
Chapter 9 illustrates in detail leveraged buy outs (LBOs): a step-by-step accounting example, capital structure analysis, value creation, valuation, and structuring are presented and a final Excel modelling example shows a LBO (majority) equity deal. Chapter 10 provides an overview of the most common exits (initial public offering (IPO), trade sale, secondary buy out) from a private equity deal.
Chapter 11 illustrates the most common methods used to structure a debt facility: among the areas covered, debt capacity, covenant, security package, and repayment structures form the core analysis. An Excel modelling example of structuring a loan facility reviews in practice all the topics.
The fourth and final section looks at the main legal aspects of a transaction and at the main symptoms and remedies of financial distress.
Chapter 12 covers all the legal aspects of a deal. In addition to the confidentiality agreement, the mandate, and the term sheet that characterise the pre-due diligence phase, the following contracts are used in a deal:
private equity: constitutional documents, investment contract, and shareholders' agreements;
private debt: financing contract (also typical of leveraged buy outs, or private equity majority deal through financial leverage) and security agreements.
Chapter 13 provides an overview of distress symptoms and remedies. After a review of early warning signals and the main causes of distress, legal and financial restructuring options are reviewed.
NOTE
1
Wilhelmus, J., W. Lee.
Companies Rush to Go Private
. Milken Institute, 2018.
CHAPTER 1Closed End Funds
A CLOSE UP ON PRIVATE EQUITY AND PRIVATE DEBT PARTNERSHIPS
A private equity fund is a collective investment scheme used for making minority or majority equity investments in private (i.e. non-listed) firms. A private debt fund is a collective investment scheme used for effecting loans or subscribing bonds in private firms.
At inception, investors make an unfunded commitment to the limited partnership, which is then drawn over the term of the fund. A private equity (debt) fund is raised and managed by investment professionals (who find, analyse, invest, monitor, and implement value creation actions in private firms) of a specific private equity (debt) firm. The goal of managers is to maximise investors' returns from invested capital.1
Institutional private equity funds are usually structured as limited partnerships (although funds that are intended for retail use often have other legal forms, such as listed vehicles) with a fixed term of up to ten years (often with annual extensions of the agreed upon investment period and fund life). A partnership has a fixed contractual term: therefore, the investment is illiquid during that time, unless the investor decides to sell the partnership on the secondary market. The main participants to a private equity (debt) partnership (see also Figure 1.1) are:
General partner (GP):
the manager is called the general partner and has potentially unlimited liability for the actions of the fund. To put a cap on this potentially unlimited liability, GPs are limited companies or partnerships. The GP interest is the fund manager's participation of his capital in the fund. Technically, the fund manager invests in the general partner; however, in common usage, limited partners are investors and GPs are fund managers. GPs are compensated with an incentive allocation of capital appreciation, called carried interest. Loss carry-forwards in the partnership structure ensure that GPs do not receive their incentive allocation until all the losses of limited partners have been recovered. Similarly, claw-backs in the structure ensure that GPs do not receive an over-distribution of gains. Hurdle rates ensure that GPs do not receive an incentive allocation until investors recover their original investment and make a preferential rate of return on their investment. When the structure does not foresee a management company, the GP is entitled to also receive the management fee.
FIGURE 1.1 A typical private equity (debt) fund structure.
Limited partner (LP):
external investors are called limited partners because their total liability is limited to the amount they invest. LPs must qualify as accredited or professional investors before they can enter an investment partnership as limited partners. In the US (but in other continents similar rules apply), the definition essentially sets a minimum net worth or minimum annual income; there are also limitations on employee benefit plan assets when admitting new LPs. A prospective LP should be aware of the percentage of the partnership assets that his or her capital represents with regard to risk as well as with regard to regulatory issues.
Management company (MC):
the management company provides management services to the fund. It is usually owned by the general partners of the fund and is rewarded for its services by way of a management fee. Moreover, because GPs usually have an advisory role with the investee companies, a management company can earn advisory fees for work carried out on behalf of these companies. The partnership agreement should determine the costs that will be carried by the partnership (legal and accounting fees are usually borne by the limited partnership).
The partnerships are generally specialised by type of company, investment stage, industry, and source of transaction. Typically, a single private equity (debt) firm will manage a series of distinct private equity (debt) funds and will attempt to raise a new fund as the previous fund is fully invested. The investment management companies will usually form a new partnership every two to four years, when the prior partnership's capital is almost entirely committed to a portfolio of companies. Fundraising hence takes place at three to four year intervals: this means that in the third or fourth year of Fund I, they will be fundraising for Fund II, and so on. Some funds, such as secondary funds, have been investing more rapidly in recent years and therefore raise funds more often. New partnerships are generally formed by first contacting investors who were involved in the earlier partnership and are known to the management. Prospective investors then conduct due diligence with regard to the fund. If the outcome of that process is satisfactory, investors will commit to the fund and negotiate terms with the fund's manager. Thus, investment power is limited to the GP manager. LPs are not involved in the investment process at all. Therefore, all private equity (debt) investors are entirely passive in the legal sense. The combination of passive investment and long fund lifetimes makes this asset class unattractive for some investors, and it illustrates the need for specialist managers.
Partnership managers receive a compensation which consists of two components:
Management fee:
annual payment made by the limited partners in the fund to the fund's manager to pay for the private equity (debt) firm's investment operations. Usually, the management fee is initially based on the total investor commitments to the fund (i.e. the fund size) and, after the end of the investment period (usually three to five years), the basis for calculating the fee will change to the cost basis of the fund, less any investments that have been realised or written-off (hence on the net asset value). Management fees rates will range from 1.0% (for private debt funds) to 2.0% (for private equity funds) per annum during the investment period, and will then often step down by 0.5–1.0% from the original rate through to the termination of the fund.
Carried interest:
a performance fee that rewards the manager for enhancing performance. In order to receive carried interest, the manager must first return all capital contributed by the investors and then return a previously agreed-upon rate of return (the ‘hurdle rate’ or ‘preferred return’, customary at 3–4% per annum (p.a.) on private debt funds and 7–8% p.a. on private equity funds) to investors. The extra-performance over and above capital returned and the hurdle rate is then split between investors (80–85%) and the manager (15–20%). Private equity (debt) funds distribute carried interest to the manager only upon exit from all investments (loans), which may take years. Carried interest on a deal by deal basis (rather than fund) has nearly disappeared.
A slightly more complex formula for distribution is synthetised by the following clause:
The investors receive 100% of commitments advanced and a preferred rate of return (hurdle rate).
The carried interest holders receive 100% of all distributions until such time that they have received 25% of the investors' preferred return (1 above). This is referred to as ‘catch up’.
Thereafter the remaining distributions are split as follows:
80% (or 85%) to investors.
20% (or 15%) to carried interest holders.
CASH FLOWS, J CURVE, AND RETURNS
An investment in a private equity (debt) fund is different from other asset classes because it represents an investment in a stream of cash flows. Unlike with a bond, where there is usually only one cash outflow, with a private equity fund there is a range of cash outflows as money is drawn down by the GP. When a fund needs cash, the GP will issue a draw down notice (capital call). This will request that an amount of cash be paid to a particular bank account by a certain date, and it will give details as to what the money is needed for. The LP will check that the cash is the correct amount, and that it is being used for valid purposes under the Limited Partnership Agreement. It will then make the necessary bank transfer. Importantly, funds are not usually allowed to draw down money to hold on account, though they may do so in anticipation of a particular transaction that they expect to close imminently. They will often return it and draw it down again if the transaction does not complete.
Figure 1.2 below summarises the typical timeline of a private equity (debt) fund. Before the first closing (which occurs when the minimum amount of the fund is reached), commitments are sought from investors. After the first closing, fundraising continues (usually for an additional 12–18 months) and the investment period starts. Capital calls for management fees and other costs occur from Year 1 until Year 9 or 10, while capital calls for investments occur throughout the duration of the investment period. Distributions occur when
dividends and divestments from a portfolio company occur in a private equity fund;
interest and principal repayment from a portfolio company occur in a private debt fund.
Since both the timing and number of cash flows are completely uncertain, private equity returns are not measured annually, but are measured on a compound basis. This is important to note when comparing private equity returns to returns of other asset classes. In the early years of a private equity fund, its returns will be negative because money is paid into the fund before any money is paid back by the fund upon realisation of investments. Eventually, however, the value of cash coming in will match the value of what is going out. At that point, the internal rate of return (IRR: compounded return over time) of the fund will be zero. This is referred to as the J-curve (see Figure 1.3 for a graphic representation). The J-curve is produced by consideration of the cumulative return of a fund in each year of its life: the first entry will represent the IRR of the fund for the first year of its life; whilst the second entry will represent the IRR of the fund for the first two years of its life; the third of the IRR for the first three years; and so on. An important element to bear in mind is that the IRR is likely to be more accurate toward the end of the fund than during the early stages of the fund's life (when it is still under the effect of the J-curve, both at individual transaction level and fund level). It is also important to remember that – due to the fact that the life of a fund tends to be much longer for a venture fund relative to a buyout fund2 – IRR should therefore be used with caution during the first six years or so of the fund's life.
FIGURE 1.2 Timeline of private equity (debt) fund.
FIGURE 1.3 J-curve effect in a private equity (debt) fund.
During the life of a fund (i.e. before it has fully divested its portfolio), investors receive an annual (or infra-annual) valuation of the fund. Valuation is one of the major issues of concern raised with regard to investment in private equity funds. One of the reasons given for this concern is that private equity returns contain a substantial element of illiquid, unrealisable capital gain that is represented only by a portfolio company having been written up by the GP.
Returns are measured on a vintage year basis. The vintage year return always states the compound return of all constituent funds formed during the vintage year, from the vintage year to a specific date. In practice the specified date is normally at the end of the last complete year for which the figures are available. The upper quartile is the data point in a sample population that is precisely one quarter down from the top in order of ranking. The upper quartile is the best way of evaluating the vintage year. The upper quartile figure describes the condition of each separate fund at the bottom of the upper quartile, not the overall condition of all the funds within the upper quartile. It does not state the range of returns present in the upper quartile, which can be very substantial indeed. It is worth noting that private equity (debt) returns that are calculated as the IRR on cash flows will always be stated net of fees, costs, and carried interest. This is because the IRR is calculated on the basis of cash going into the fund and cash being taken out of it. It is important to note this because the returns of many other asset classes are often quoted before fees. Therefore, if it is seen that private equity (debt) returns are being quoted against other asset classes, it should be questioned whether they are vintage returns being compared to vintage returns, and also whether the figures for the other asset class are stated before or after fees.
Although IRR is widely accepted as the correct measure of performance, multiples are another important measure of private equity and private debt funds. The money multiple is the most important measure of performance. At company level, the money multiple is the ratio between total cash realised by disposing of that interest, by the total cash invested in a company, regardless of how many cash flows may be involved. For example, if $2.5m is paid into a portfolio company and $5m is received back, the money multiple will be 2x. It doesn't matter how many single cash flows are involved, or over what period they take place – though this is relevant to transaction IRR. Whatever money multiple is used, it can only have been generated in gross terms by the money multiple achieved on the fund's underlying portfolio companies. There is usually only one way of calculating the money multiple that is earned on a firm, and that is by considering the actual amount paid out and the actual amount received. Other typical indicators to measure a fund performance are:
Distributed over paid in (DPI):
measures the ratio of money distributed by a fund against the total amount of money paid into the fund. At the start of the investment, this ratio will be zero, and will begin to increase as distributions are paid out. When the DPI is equal to one, the fund has broken even, as money paid in is equal to money distributed, and any number above this indicates that the fund has paid out more than has been paid in.
Total value to paid in (TVPI):
measures the overall performance of a fund with a ratio of the fund's cumulative distributions and residual value to the paid-in capital. It calculates what multiple of the investment would be returned to investors if the unrealised assets were sold at current valuations and added to distributions that had already been received. It is very helpful in measuring the distributions received to date, as well as the residual value of the remaining investments. While DPI provides a clear measurement of the actual multiple of cash invested that has been received by an investor, TVPI provides a metric that accounts for potential returns that are the result of increased valuations of portfolio companies as they approach exit. Given this difference, many LPs rely on TVPI earlier in the life of a fund and DPI towards the end.
FINANCIAL RETURNS
Investors in private equity funds expect to receive returns of 500 to 1000 basis points (bp) more – calculated on a comparable levered basis – than they might expect to receive from public securities. Although private equity investments are viewed as being considerably more risky than public market investments, sophisticated institutional investors have been committing increasing amounts of financing in this area. Private equity has therefore become an accepted element of most diversified institutions.
Dividends and realised capital gains are the two components of the financial returns that accrue to investors.
Dividends are the portion of the company's profits paid out to shareholders. Payment takes place on a pro-rata basis depending on each shareholding percentage held in the company. Dividends are paid out if the company has realised a profit (or has sufficient accumulated reserves) and their amount depends either on the enterprise's dividend policy or on ad hoc decisions of the shareholders. There is usually no obligation for a company to pay dividends to its shareholders, except in such cases where a clause establishing a compulsory dividend pay-out ratio (always subject to the company being profitable) has been included in the shareholder agreement. Since dividend distribution affects the returns of an investor, shareholders always face the trade-off between allocating net earnings to capex (thus allowing the company to grow further) or to dividend payments.
A capital gain is a profit that results from the sale of the portfolio company at an amount higher than the purchase price. Usually, the majority of the investment's return comes from a realised capital gain on exit as opposed to dividend payments. Returns will be higher the higher the exit price and the lower the price paid at entry. The investment's degree of liquidity will also play a significant role in achieving higher, lower, or any returns at all.
As said above, IRR (investment's annualised equivalent compounded return rate or, in other words, the yield that would be produced by an investment with regular annual payments and overall same return as the one under consideration) and cash on cash multiples are the most widely used metrics to assess and compare the returns of a transaction. Time (as Tables 1.1 and 1.2 below show) plays a crucial role in determining the final outcome.
In order to make the correlation risk/reward inherently coherent, and since – in case of equity – the equilibrium between risk and return is more unstable (due to a number of factors such as company, sector, governance, exit), the expected ex ante return for equity investment tends to be significantly higher than the one for debt securities.
TABLE 1.1 IRR (%) as a function of time and cash on cash exit multiple.
Multiple/years
2x
2.5x
3x
3.5x
4x
5x
6x
8x
10x
2
41
58
73
87
100
124
145
183
216
3
26
36
44
52
59
71
82
100
115
4
19
26
32
37
41
50
57
68
78
5
15
20
25
28
32
38
43
52
58
6
12
16
20
23
26
31
35
41
47
7
10
14
17
20
22
26
29
35
39
8
9
12
15
17
19
22
25
30
33
9
8
11
13
15
17
20
22
26
29
10
7
10
12
13
15
17
20
23
26
TABLE 1.2 Cash on cash (X) exit multiple calculated as a function of time and IRRs.
IRR/years
15.0%
17.5%
20.0%
22.5%
25.0%
27.5%
30.0%
32.5%
35%
1
1.15
1.18
1.20
1.23
1.25
1.28
1.30
1.33
1.40
2
1.32
1.38
1.44
1.50
1.56
1.63
1.69
1.76
1.96
3
1.52
1.62
1.73
1.84
1.95
2.07
2.20
2.33
2.74
4
1.75
1.91
2.07
2.25
2.44
2.64
2.86
3.08
3.84
5
2.01
2.24
2.49
2.76
3.05
3.37
3.71
4.08
5.38
6
2.31
2.63
2.99
3.38
3.81
4.30
4.83
5.41
7.53
7
2.66
3.09
3.58
4.14
4.77
5.48
6.27
7.17
10.54
8
3.06
3.63
4.30
5.07
5.96
6.98
8.16
9.50
14.76
9
3.52
4.27
5.16
6.21
7.45
8.90
10.60
12.59
20.66
10
4.05
5.02
6.19
7.61
9.31
11.35
13.79
16.68
28.93
The following tables (Table 1.3 and 1.4) summarise the required return as a function of product and the company stage and product.
TABLE 1.3 Target return as a function of instrument.
Stage
Indicative target return (%)
Ordinary equity
>25
Ordinary equity (with special rights)
>20
(Redeemable, convertible) preference shares
12–25
Mezzanine (with warrants)
12–20
Loans with equity linked return interest step up, convertible
8–20
Senior unsecured debt
6–8
Senior secured debt
3–5
TABLE 1.4 Target return as a function of the company stage.
Stage
Indicative target return (%)
Start-up
>40
Early expansion capital
>30
Growth equity
>20
Quasi equity (mezzanine etc.)
15–20
Portage
3
and equity dressed debt
10–15
Senior acquisition debt
3–5
Senior capex debt
2–4
REFERENCES AND FURTHER READING
H. Cendrowski, L.W. Petro, J.P. Martin, and A. Wadecki. 2008.
Private Equity: History, Governance, and Operations
. Wiley Finance.
G.W. Fenn, J.N. Liang, and S.D. Prowse. 1995. ‘The Economics of the Private Equity Market.’ Staff Studies from Board of Governors of the Federal Reserve System (U.S.), No 168.
G. Fraser-Sampson. 2007.
Private Equity as an Asset Class
. Wiley Finance.
J. Lerner. 1984. ‘A Note on Private Equity Partnership Agreements.’ Harvard Business School Note 9-294-084. January.
J.S. Levin and D.E. Rocap. 2009.
Structuring Venture Capital, Private Equity, and Entrepreneurial Transactions
. Wolters Kluwer.
SUGGESTED CASES
J. Lerner. 2015. ‘Yale University Investments Office: February 2015.’ Harvard Business School Case 815-124.
J. Lerner. 1995. ‘Acme Investment Trust.’ Harvard Business School Case 296-042.
NOTES
1
