Reading 33: Private Equity Investments

Page No 29Date//Reading 33 PrivateEquityInvestmentsPossible Sources of Value creation in private equityBoReenginner firm for more efficient operations - bring expertiseobtain lower-cost debt financing via syndicated access loan to clocheapcredit and few coveanantsHY bond CDOParallel goal alignment bet many? & private equity ownersAgency Conflict manyPrefrence shareAlignment of Eco CCPPS- IntcumulativeGnverleineparticipatingSet on boardManagers focus on long-term performance over short -term (Public)Mechanism to align int of private equity firm 4foliocompany managers specified in term sheetsheet:Examples of control mech specified in term- Compensation : closely linked to performance &promotegoals achievement- Tay along clause : management has exit rights Non il PE firmsells its stakecompetePriority-claim -*Valuation Characteristics of VC InvestCorporate board setApprovalsCF - unpredictedProduct - uncertain future based IP on new techAsset base - weak R&D & inteMang" team tangible - strong entrepreneurial record Page No. 30.Date / /Levelage - little debt, mostly equityRisk assessment -difficult to measureOperations - high cash buin ratemultiple round of fundingExit strategy - unpredictableCIPOor firm sale)Capital req in growthphaseReturns from few highlysuccessful invest with write-offsfrom many failuresNotactive in public capital marketsFuture funding - less scalableCarried int most commonnotransaction&GP make money by thismonitoringfeesValuationCharacteristics ofBuyoutInvestCF - Stable and predictableEstablishedproductsqustedSubstantialasset base langibleDebt as multiple is of EBITDAExperiencedmang" teamHighlyleveragewithseniordebtFinancing to tak privateRisk can be assessed from mature operationsExit strategy is predictableReduction inoperationalinefficienciesLow workingCapital reqLow variabletyfinalsforin success t , rare failureActive inpublic Capital marketsSubsequentfundingeasywithstrongperformanceCarried int 7 transaction & monitoring fees. Ratchet = Allocation of equity bet" LP &GPPage No. 31Date / /ValuationIssues in Private EquityValuation IssueBuyoutVCUse of DCFFreq usedUncertain CFRelative valuevalidates DCFNo CompsUse of debtHighLow, more equitsKey return driversEPS growth t PIE expansionPre-money valuation,debt reductionfuture dilutionPre Invest valuePre - money Valuation (PRE) :Value of a company before making investPost - money valuation (POST) :Value of a Company after making investVC investors proportionate ownership : Invest / POSTPost = PRE + INVComponents of Performance from a leveraged BuyoutExit Value = Invt cost t earnings growth + multiple expansion +reduction in debtEarnings growth due to operationalefficienciesIncrease in price multiple due to increased growthApply scenasio analysis to forecasts Page No 52Date / /Venture Capital Method : Single Financing RoundWPonder Tech is a biotech Co. Ponder's founders to believe Invest Regthey can Sell the CO for $40m Exit value in five yr. They need $ lmin Share capital now, and the entrepreneours Currencetly hold ImThe venture Capital firm VC Investors, decides that given theCalculate high risk of this Company 7 an Rol of 10x is appropriate.fraction, & price per share applying the VC method 114=58.49the pre-money Va luation post-money multip valuation t ownershipN=5FV=10Post = $40,000,000 = $4,000,00010 ImVc 251 3m foundelfundPre = $4,000,000 - $1,000,000 = $ 3,000,000Shares seq for VC firm : Svc = set £(1-F)Svc= 1,000,00025= 333,333(1-0.25)Im 333,333Price per share : $1,000,000 = $ 3$3333,33VC Method : Multiple RoundsInviThe New Gadget Co will need $1.5 M in the first round & asecond round of financing of $25 InV2 m to the finance Coexpansion to the Size expected at exit. The exit value was Page No. 33Date//initially est at $ 160 Ev M&wasrevisedto duting$400 mEV2the secondround.While the firstfoundofinvestorsdemands an Rol of 20theSecondroundofinvestorsaccepted an Rol of 5xStagelStage 2Invest1.525Rol205Exit Value160400Post = exit value (Rol8.080Pre = Post - Invst6.50518.75% 1.525f = INV / Post31.257.80Founder81.25% 8DilutionofRoundIInvestors&FoundersAfterthesecondroundthefirst-roundinvestor's(& founders )ownershipsharewillbedilutedFirst found dilutionby31.25%Eve = 0.1875 (1-0.3125) F 12.89%Founders =0.8125(1-0.3125)=55.867.dilution for foundarTotal ownership = 12.89% + 55.86%+31.257= 100%ExitRoutes&PEValue1Initial Public offering (IPO);Pros-Highestexitvalue(higherliquiditytaccess to Capital,& attractgoodmanagement Page No. 34Date//Cons - Less flexible more costly & ComplexWhen to use - Strong growth prospects operating history, SizeTiming is keyI2Secondary Market Sale:- Sale from one firm to anotherfor strategic reasonsPros - Second highest valuation3 Manay" Buyout :- Firms sold to manag" with significantuse leverage3Liquidition :- Outright sale of firm's assets firm no longer viableCon - Lowest valuation, Ve public perception.Private Equity DetailsStructure : Limited partnership (LP) provides funding t no activerole liability GP liable for all debtandunlimited liabilities t 10-12 yr livesTerms : Qualified Investor only with 1 $10m in assetsManagh fees - 2%Carried int - GP's share of profitsRatchet - Allocation of folio company equity bet shareholderand many" Page No 35Date//Hurdle Rate - IRR target before GP can receive carriedint (. - 10%)Target fund size - Signals GP's ability to raise fundsbelows is -ve singnalVintage - Yr fund was started (Relevant Risk )Valuation :- NAV with freq adj Value of folio lirmsDue Diligence :- Evaluation of past performanced trends &magnitude.Example : Carried IntA fundhascommitted Capital of $100m , carried int of 20%and a hurdle rate of9%The firm called 80% ofitscommitted in the bey yrl of this $50m was invested inCo A and $30m in CoBAt the end of Yr2 a $7m profit is realized on the exit fromCA The invest in 6B is unchanged The carried int isCalculated on a deal -by - deal basis (i.e the IRR for determiningcarried int is calculated for each deal upon exit )Determine the theoretical carried int & the actual carried intSol" Theoretical carried Int : 20% X $7,000 000 = $1,400,000IRR for (o A ; PV = - $50 FV = 57 N= 2CPT 1/46.87.Because the 6.8% IRR is less than the hurdle rate of 9%no Carried int is actually paid. Page No. 36Date//Risks in Private Equity Invest"Liquidity Risk - Not publicly tradedCompetitive environment lisk -Fewer deals with good prospects at lowAgency Risk - Principal agent ConflictCapital Risk - Withdrawal of Capital due to increase inbiz & financial riskRegulatory Risk - Adversegovt regulationTax Risk - Treatment of returns changesValuation Risk - Refects subjective judgmentDiversification Risk - Poorly diversified across stage, vintage & strategyMarket Risk - Long -term factors such as int rates & exch ratesCosts of Private Equity Invest"GPTransaction costs - Due diligence, bank financing legal feesFund set up costs - Usually amortized over life of fundAdministrative costs CustodianAgents - transfer agent & alc costscharged yolyAduit feesManag' fees = 2%Performance fees = 20%Dilution costs" ,- Resulting from additional rounds of financingand stock optionsPlacement fees :- As much as a 27.up-lient fee of annual trailer paid to placementagents Page No. 32Date//Financial performance of PE funds from investor perspectiveGross IRR : % return earned by the firmostNet IRR : % return earned by the LPsPaid in Capital (PIC) : PIC / commited capital = % of Capital called by GPDistributed to paid -in capital (DPI) : Cumulative distribution paid to LPS /Measures LPs realized return Cash-on-lash cumulative invest capitalResidual value to paid-in capital return (RVPI) : Value of the LPs holdingsin the fund I cummulative invested capital Measures LPs unredizedreturnTotal value to paid-in capital(TVPI):DPI + RUPIRecommened :GIPS since inceptionIRR:- SI RR is a money -weighted return:-AssumesintermediateCFreinvestedatIRRbutPEfundstend to be illiquid:- Gross or net of feesbeilgitium:- Considerstime value of moneyMultiples : Popular 7 simple easy to use & diffbetrealizedand unrealized returns, specified by GIPSPaid CapitalEvaluating a PE fundsManagn fees : % fees X Total paid-in CapitalCarried int : % callied int X Increase in NAV before distributionNAV before distribution : NAV after distribution, + Capital called down-NAV after distribution : NAV before distribution Carried int - distributionmangn fees + operating results Page No. 38Date//ExampleThe GP of a PE fund charges a managements fee of 2% &Carried int of 20% which is paid after the folio valueexceeds the commited capital of $150mPaid in ManyOperatingNAV beforeCarried IntYrCalled-Down-CopitalCapital fees(27.)ResultsDistribut20%115050(1)(10)390STREEM122070(1.4)(15) lost32.601330100(2)2585.601420120(24)50153.2(0.6)1510130(2-6)60200(9.4)1610140(28)110267-8(13.6)Carried int : Paid when NAV before distripution > CommittedCapital, which first occurs here in 2014 Carried int is 20%multiplied by the NAV d before distribution - the committed Gptial20 X (153.2 - 150) = $0.6Subsequently, Calculate using the increase in the NAV beforedistributionEg in 201520 X (200-153,2)=$9.4NAV before distributions :Priors yr NAV after distbns t Capital called down -mmt fees t operatingFor ex in 2015:results132 .6 + 10 - 26 +60 =$200 Adj r 1-9 Hr-1Page No. 39Date//NAV after distributionNAV before distributions - Callied int - distributionsFor ex in 2015, NAV after distributions is200-94-40 - = $150.6Distributions NAV after2016 OPIDistributcalulated as the cumulative distribution divided039by the cumulative paid-in capital;032.6camulative Dist085.6DPI = 20 + 40 + 80= 1(20132.6140 Paid in capital(90) #40150.6This indicates that, in terms of distribution(80)174.2returns t the fund has returned every dollarinvested2016 RVP)Calculate as the NAV after distributions divided by theCumulative paid- in - capital Nav ofter distRVPI = 174.2 =1.24140Paid in CapitaThis indicates that, although the distribution retures are notimpressive for this fund ( the fund has unsealized pifitsthatshould accue to LPs as invest" are harvested.TVPLThe TVPI multiple is simple the sum of the DPI & RVPITvpl = \ + 1.24= 2.24