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Private Equity and Venture Capital

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Private Equity and Venture Capital 1st master class at the Higher School of Economics

Private Equity and Venture Capital 1st master class at the Higher School of Economics

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  • 1. PRIVATE EQUITY AND VENTURE CAPITAL MASTERCLASS Session 1. Private Equity landscape March 2013 Alexey Milevskiy Gleb Fomichev The presentation is prepared solely for the purposes of master classes at the Higher School of Economics
  • 2. INTRODUCTION 2
  • 3. Speakers Alexey Milevskiy Alexey Milevskiy is an Investment Manager at UFG Private Equity, leading Private Equity firm managing over $500 million across several funds in Russia and CIS. He participated in all stages of investment process: origination, due diligence, structuring and execution. Prior to UFG PE Alexey worked at European Private Equity division of GIMV in Belgium, KPMG Business Valuation group and ING Bank. Alexey holds masters degree from Vlerick Business School, Belgium and bachelors from Higher School of Economics. He is also the winner of several McKinsey&Co business case competitions. Gleb Fomichev Gleb Fomichev is an Analyst at JSFC Sistema, major Russian investment company. Gleb is one out of 7 investment professionals running Sistema’s $2 billion portfolio of high technology assets. He is engaged in strategy development and portfolio companies management as well as in new deals origination. Prior to Sistema Gleb worked at A&NN Group, one of the top performing Russian family office, where he managed fund’s assets in retail, telecommunications, logistics, publishing and financial services sectors. Gleb’s other experience includes E&Y business valuation team. Gleb holds masters and bachelors degree from Higher School of Economics. 3
  • 4. UFG Private Equity • Over $500 million of capital under management • Strong and experienced team of 11 investment professionals • 5 partners worked as CEO/CFO or had own businesses, one partner is involved as CEO or a portfolio company • Strong track record with 19 investments in FMCG, Consumer and Business services, Metals and Mining, Banking, Specialty Retail, TMT, Food and Beverages, Healthcare, Travel sectors with aggregate transaction value of over $1 billion • 7 projects were co-invested with other funds • 8 exits performed with capability to create value • International investor base including EBRD and well-known US and Middle-Eastern state pension funds • Part of UFG Asset Management group with $1.2 billion under management in four investment areas: Private Equity, Hedge Funds, Real Estate, Wealth Management 4
  • 5. UFG Private Equity Fund II portfolio companies Fund Size $225m Yandex Partially realized Rising Star Media Fully realized Russian Fund II Portfolio Towers company Enforta Fund II Portfolio company Brunswick Fund II Portfolio Rail company Fund II Portfolio KDL company Karo Film Fund II Portfolio company 5
  • 6. JSFC Sistema • Top public investment company in Russia • Market cap ~ $10 bln • Assets under management ~ $40 bln • Consists of 8 investment portfolios divided by industry/investment team competencies 6
  • 7. Session 1. Private Equity landscape 1st part • Private Equity definition; • Company funding lifecycle: FFF, business angels, venture capital, private equity, IPO; • Organizational structure of a PE fund: LP-GP agreements; • Typical activities performed by PE fund: fund raising, deal sourcing and originating, due diligence, management of portfolio companies, exits; • Key success factors for PE deals; 2nd part • Russian PE/VC landscape: PE funds, captive funds and family offices, government-backed funds, venture capital funds; • Russian vs Foreign PE industry; • Entry strategies: full buyout, growth capital, LBO, minority recapitalization, mezzanine, distressed situations. • Exit strategies: IPO, trade sale to strategic/financial investor, MBO, sale to other shareholder; • PE careers. 7
  • 8. Session 2. PE deal origination, execution and portfolio management Industry analysis March, 14 (6pm – 9pm) • Investment strategies: buy-and-build vs bet-and-win; • Industry KPIs and application for financial modeling; • Multiples variation by industries. Financial modeling and leveraged buyouts • Financial statement analysis: application for private equity; • Valuation methods: multiples approach, comparable transactions approach; • Private equity returns calculations: IRR, cash-on-cash, exit sensitivity analysis. • LBO and financing of M&A transactions: debt and mezzanine financing for PE deals. Due diligence • Commercial, financial and tax, legal due diligence Deal structuring and negotiations • Legal documents for deal execution: NDA’s, Term Sheets, SHA’s, SPA’s; • Off-shore holding structures: English law, possible holding schemes. • Deal structuring tools • Deal negotiations: habits for effective negotiations. Portfolio companies management • Fund representation on the board of directors: strategy formulation, veto and approval rights, audit and compensation committees; • Companies monitoring: weekly/monthly management reporting packs, frequent interaction with management; • Value creation strategies: fund raising, building corporate governance, management appointment, solving operational issues, attracting consultants, finding clients, exit preparation, synergy identification among portfolio companies. 8
  • 9. Private Equity definition 9
  • 10. Private Equity definition Private equity is a: • medium to long-term financing • provided in return for an equity stake • in potentially high growth • unquoted companies 10
  • 11. Private Equity value creation formula Multiple EBITDA growth Leverage Expansion Topline Efficiency growth improvement Superior returns 11
  • 12. What value Private Equity fund brings PE Entry Value creation within 3-5 years Exit Financial support - Raising new equity rounds and debt financing - Financial planning and cost control, IFRS implementation - Introducing transparent reporting system M&A support - Developing M&A strategy - Search and valuation of attractive acquisition targets - Legal support and deal structuring - Integration assistance Operational support - Help in bringing top experienced people to the team to bridge personnel gaps - Attracting independent board members and industry experts - Motivation schemes implementation - Development of tax and legal structure, IT-systems - Access to a new partner and client network, help in expanding abroad - Optimization business processes and internal decision-making Help in forming/ adapting company strategy - Business model adaptation to changing market realities - Implementing company development plan and setting KPI’s Preparing company for an IPO or trade sale - Improvement of corporate governance - Substituting investment banks at exit - Legal support and deal structuring 12
  • 13. Private Equity target returns IRR 30% Cash-on-cash 3x over 5 years 13
  • 14. Private Equity fund types FUND DESCRIPTIONS By stage By size Ownership Specialization Purpose • Venture funds: • Large-cap • Captive/semi- • Specialized • Funds-of-funds: invest in early stage funds: large LBO captive: funds funds: funds funds created to or expanding funds (could be established by and focusing on a invest in a range of businesses that greater than $20bn) with strong links to a portfolio companies other private equity generally have particular investor, in specific segments funds limited access to • Mid-cap funds: e.g. a financial (e.g. IT/ real estate) other sources of usually invest in institution funding deals worth • Regional funds: between $10m and target investments • Buyout funds: $300m in a particular region invest in mature businesses, usually taking controlling interest and leveraging their equity investment with substantial amount of third party debt 14
  • 15. Specialist/ generalist funds Specialist funds • May be attractive to certain investors, i.e. those seeking to: I. Increase their exposure in a particular sector (healthcare, IT) II. Diversify their existing geographical/sector focus • Small funds may increase specialization to differentiate themselves • Disadvantages: I. May be more risky due to the lack of portfolio diversification II. May be difficult to raise a fund if there is little investor appetite III. Niche/hot sectors may lose favor Generalist funds • Most private equity funds are generalists • General fund may have specialist teams who may source and execute deals within certain market sectors • Generalist funds have the advantage of being able to limit their exposure to declining sectors and have more flexibility 15
  • 16. Key successfactors for PE deals 16
  • 17. Investment approach and key success factors 1 Market leaders are typically winning 2 Strong and motivated management team 3 Fair entry price 4 Proper deal structuring 5 Proactive monitoring 6 Clear exit strategy 7 Industry growth and deep market expertise 17
  • 18. Investment approach and key success factorsMarket leaders are typically winning Market leaders How to are determine winning market leader? UFG cases: • Yandex • RSM • Russian Towers • Industry leader • Brunswick Rail • Industry segment leader • Russian Alcohol • Leader by market share • Leader by margins • Leader with first-mover advantage • Leader with the most known brands • Potential market leader through M&A or business scalability • … 18
  • 19. Investment approach and key success factorsStrong and motivated shareholders and the management team Goal alignment • Important to chose a partner you can Typical PE fund is deal with. High personal integrity, strong not a turnaround commercial instincts, transparency, team which is flexibility should be among the qualities of coming and taking the counterparty in the deal. operational • Choice of the trusted management team management is important • The company should not be 100% dependent on 1-2 key shareholders/ managers We are all in the same boat • Goal alignment should be in place to motivate managers and other PE The management, shareholders: fund founders Upside sharing scheme may be in place to motivate management on: I. Growing the company II. Exit 19
  • 20. Investment approach and key success factorsFair entry price Entry Fair entry price should be negotiated • Clear exit path should be overseen from the beginning • Fair entry multiple is needed to x5 EBITDA* x10 EBITDA* avoid multiple contraction at exit + Full downside and achieve good returns protection and • It is always a trade-off between: corporate rights I. low multiple II. high multiple and protection Exit mechanisms 35% IRR, 3x cash multiple * example 20
  • 21. Investment approach and key success factorsClear exit strategy Exit types To consider at the time of entry • Trade sale • Clear exit path should be foreseen at • Secondary buyout the time of entry • Sale to other shareholders/ • Partner should be focused on exit management and not to prevent it • IPO • Exit obligations may be in place to guarantee exit for the Fund in worst • Break-up case scenario • Share redemption • IPO should not be the base case: partial exit, continuing risk, lock-up period • The exit should be identified in the investment documents in terms of timing, profit-sharing, liability to exit 21
  • 22. Investment approach and key success factorsClear exit strategy: trade buyers exit scorecard example Financial Fit Strategic Fit 1. Revenue 2. Net Debt/ EBITDA 1. Product fit > 1 bln USD < 0x 1.1. Companies with services portfolio complementary 500 mln to 1 bln USD 0x to 1x to ABC which aim to: • enter ABC segment; 250 mln to 500 mln USD 1x to 3x • complement offerings for the current clients. 100 mln to 250 mln USD 3x to 5x 1.2. Companies already present in ABC segment (<50%), which aim to: < 100 mln USD > 5x • strengthen ABC segment. 1.3. Companies which aim to: Only companies with a lowLarge firms are more likely to • realize cost synergies; Net Debt/EBITDA ratio will • build market share.acquire ABC and leverage its have willingness and ability to capabilities acquire 2. Geographical fit 3. Organic revenue growth 4. EBITDA 2.1. Companies which aim to enter Russian/ emerging markets < 5% > 200 mln USD 5% to 10% 100 mln to 200 mln USD 3. Acquisitions growth fit 10% to 15% 75 mln to 100 mln USD 3.1. Companies with expressed intention in M&A 3.2. Companies which have successful past track 15% to 20% 50mln to 75 mln USD record of doing acquisitions > 20% < 50 mln USD 4. Client fit Companies with limited ABC is more appealing to 4.1. Companies which want to access new organic growth opportunities companies with a positive clients of ABC are more focused on EBITDA and aiming to 4.2. Companies which want to provide support to acquisitions maintain high margins existing multinational clients 22
  • 23. Investment approach and key success factorsProper deal structuring Proper deal The following deal structuring structuring is key elements could be used: to align parties • Put and call options, redemption and establish rights downside • Deferral consideration and earn-outs protection • Covenants • Drag along and Tag along • Share ratchets • Preferred shares and liquidation preference • Right of first refusal • Board representation and approval rights • … 23
  • 24. Investment approach and key success factorsProactive monitoring Proactive • Building 100 days plan and clear 3-5 monitoring of years roadmap portfolio • Building proper corporate governance companies is • Fund active involvement on the Board important of Directors • Monthly reporting from portfolio companies • Monthly review of budgeted and actual numbers • Early warning of issues • Frequent interaction with management • Strengthening CFO/ financial controller 24
  • 25. Investment approach and key success factorsIndustry growth and deep market expertise Examples of attractive sectors in the current environment Sector Investment rationale 1 Undeveloped industries/ sectors with high growth potential • Internet tech companies • High Internet growth rates • E-commerce • Service infrastructure is still • Medical Services underdeveloped • Fast Food • Limited modern private medical services • Logistics 2 Traditional sectors • Food retail • Import substitution • FMCG • M&A opportunities, important to find right • Pharmaceutical industry platform for consolidation • TMT • Regional growth potential • New formats/ products development • Room for improvement (margins, working capital) 25
  • 26. Investment approach and key success factorsIndustry growth and deep market expertise Two investment strategies “Bet-and-win” “Buy-and-build” • Industry with high growth potential • Good industry knowledge • Investment in market leader • Building market leadership through M&A • Investment in strong management • Strengthen management team team • “Discount entry price” • “Fair entry price” • Majority stake buy-out • Minority investment Undeveloped industries/ sectors with Traditional sectors high growth potential Common principles • The market in which the Company operates should be at least $100 million • The demand for the Company products or services should be justified by macro trends • The business model should be proven/ sustainable/ scalable 26
  • 27. Sequoia Capital investment approach ELEMENTS OF SUSTAINABLE COMPANIES Start-ups with these characteristics have the best chance of becoming enduring companies. We like to partner with start-ups that have: 1 CLARITY OF PURPOSE Summarize the company’s business on the back of a business card. 2 LARGE MARKETS Address existing markets poised for rapid growth or change. A market on the path to a $1B potential allows for error and time for real margins to develop. 3 RICH CUSTOMERS Target customers who will move fast and pay a premium for a unique offering. 4 FOCUS Customers will only buy a simple product with a singular value proposition. 5 PAIN KILLERS Pick the one thing that is of burning importance to the customer then delight them with a compelling solution. Source: Sequoia Capital 27
  • 28. Sequoia Capital investment approach 6 THINK DIFFERENTLY Constantly challenge conventional wisdom. Take the contrarian route. Create novel solutions. Outwit the competition. 7 TEAM DNA A company’s DNA is set in the first 90 days. All team members are the smartest or most clever in their domain. “A” level founders attract an “A” level team. 8 AGILITY Stealth and speed will usually help beat-out large companies. 9 FRUGALITY Focus spending on what’s critical. Spend only on the priorities and maximize profitability. 10 INFERNO Start with only a little money. It forces discipline and focus. A huge market with customers yearning for a product developed by great engineers requires very little firepower. Source: Sequoia Capital 28
  • 29. LP-GP agreements 29
  • 30. Private Equity fund structure terminology Investors which allocate money to PE/VC funds. They commit money directly (e.g., Limited Partners (LP) Family Offices), or on behalf of others (e.g., Pension funds) PE/VC fund manager who raises General Partners (GP) money through a fund legal vehicle Investee companies or entrepreneurs who get Investee company money and generate returns for GPs and LPs 30
  • 31. Private Equity fund structure Limited Partners Distribution Institutional investors of proceeds • Pension funds • Sovereign wealth funds • Financial institutions HNWI Disbursement of commitments Carry Fund General Partners PE or VC firm Equity Exit Investment proceeds Investee company 31
  • 32. Private Equity fund landscape LP LP LP GP GP GP GP GP GP C C C C C C C C C 32
  • 33. LP-GP relationship Limited partnership structure entails arms’ length relationship and a five-ten year commitment • LPs choice comes out of a solving a broader asset allocation problem, which includes: risk/return, liquidity, transparency • LP makes three decisions: 1. Alternative assets among all investment options 2. VC/PE within alternative assets 3. Choice of the fund manager (GP) - the most important! • Once a GP is selected LPs want to ensure they will earn high returns. This requires that: 1. GPs do not act opportunistically 2. GPs devote full effort to the ‘fund’ 3. Right companies are selected 4. GPs report their returns faithfully 5. Exits from companies are efficient • GPs have to raise funds and choose LPs. • They also need to manage long-term relationships, as fundraising is repeated. • For this, they need to generate high returns (at least the perception of them) • GPs want LPs to provide commitments on time and keep their investment decisions as independent as possible 33
  • 34. LP-GP relationship Criteria for selecting GPs in first funds Partners previous success in PE Proposed investment strategy Quality of the partners network of contacts Partners previous experience in working together The level and structure of fees Partners previous experience in non-PE jobs The funds size Partners quality of education Commitments to this fund by top LPs The opportunity to access follow-on funds Co-investment opportunities The advisor opinion 0 1 2 3 4 Source: Marco Da Rin 34
  • 35. LP-GP relationship Criteria for selecting GPs in seasoned funds Proposed investment strategy Stability of the team at partner level GPs reported aggregate multiples on previous funds GPs reputation GPs reported IRR on previous funds Quality of the partner network of contacts The level and structure of fees Renewed commitment to this fund by its existing LPs The funds size Valuation of unrealized investments (NAV) in GP portfolio The change in fund size from previous funds Commitments to this fund by top LPs Partners quality of education Co-investment opportunities The advisor opinion 0 1 2 3 4 Source: Marco Da Rin 35
  • 36. LP-GP relationship Reasons for refusing re-investment 30% 20% 10% 0% The funds size Strategy changed Disappointing Key GP partners left Other reasons increased too much performance 36
  • 37. Typical PE/VC fund remuneration structure Management fee 2% LP GP Carry 20% Management fee of 2% is charged on the total amount of committed/invested capital. Carry is received upon exit from portfolio investments. • First, LPs get total commitments at cost plus hurdle rate (8-10% annual). • Second, remaining exit proceeds split while 80% goes to LPs and 20% to GPs. Carry is the main part of total remuneration and its existence ensures that the interests of LPs and GP are aligned and GP focused on value maximization and successful exits. 37
  • 38. Typical PE/VC fund remuneration structure: simplified example Management fee 2% LP GP Carry 20% $300mln fund 1 Management fee 300*2% = $6mln annually 2 Carry Assumption that the fund makes 3x cash-on-cash over 5 years Exit proceeds 3*300 = $900mln 1) Cost plus hurdle goes to LP: 300*(1+0.08)^5 = $441mln 2) LP gets 80% of remaining proceeds: 80%*(900-441) = $367mln 3) GP gets carry of 20%: 20%*(900-441) = $92mln 38
  • 39. Alternative structure of Family Office or captive PE fund PE/VC fund integrated with an investor LP • Family office • Captive fund May have different goals: • No need to raise funding • Non-financial goals GP Companies 39
  • 40. Company funding lifecycle 40
  • 41. Company funding lifecycle Revenue IPO Private Equity Venture Capital Business angels FFF Time Start-up Early Growth Mature 41
  • 42. VC funding lifecycle Funding stage Source of investment Use of proceeds Size, USD Start-up competitions, grant Incorporation of a company, building Grant programs prototype, first sales Angels, seed stage VC firms, Seed Developing product to first sales up to 1m qualified investors Primarily VC firms, other qualified Round A Scaling operations 1m-3m investors and sometimes angels Primarily VC firms, other qualified Round B Scaling operations, new markets entry >3m investors and sometimes angels Scaling operations, strengthening brand, Round C and Primarily VC firms, other qualified new markets entry, technology >3m later rounds investors improvement (ERP, CRM, etc.) Expanding business, providing exit for early IPO Equity capital markets undefined investors Source: Fast Lane Ventures 42
  • 43. Typical activitiesperformed by PE fund 43
  • 44. What value Private Equity fund brings PE Entry Value creation within 3-5 years Exit Financial support - Raising new equity rounds and debt financing - Financial planning and cost control, IFRS implementation - Introducing transparent reporting system M&A support - Developing M&A strategy - Search and valuation of attractive acquisition targets - Legal support and deal structuring - Integration assistance Operational support - Help in bringing top experienced people to the team to bridge personnel gaps - Attracting independent board members and industry experts - Motivation schemes implementation - Development of tax and legal structure, IT-systems - Access to a new partner and client network, help in expanding abroad - Optimization business processes and internal decision-making Help in forming/ adapting company strategy - Business model adaptation to changing market realities - Implementing company development plan and setting KPI’s Preparing company for an IPO or trade sale - Improvement of corporate governance - Substituting investment banks at exit - Legal support and deal structuring 44
  • 45. Typical activities: big picture Pre-deal Deal origination Deal screening Due Diligence Deal Negotiation Structuring Deal sourcing Company Post-deal management, Exit value creation 45
  • 46. Deal sourcing Reputation Proactive research Investment strategy Deal sourcing Direct approach Intermediaries Personal/ professional network 46
  • 47. Deal origination and execution 1 2 3 Deal teaser received Quick screening Signing NDA - Proactive search - Meeting with - Conferences management/ - Proprietary connections shareholders - Investment bankers 4 5 6 Reviewing info pack Market research Financial modeling - Information memorandum - Expert interviews - Returns calculation - Business plan - Sensitivity - Additional meetings - Stress tests 7 8 9 Negotiations Investment Committee Due diligence - Deal price - Preparing docs - Consultants tender - Deal structure - Working with consultants - Reviewing VDR 10 11 12 Final negotiations Deal docs drafting with Deal closing and - Final price and terms lawyers and signing payment adjustment based on DD - SPA - party findings - SHA 3-12 months 47
  • 48. Deal screening example Number of deals Deal received 500 Signing NDA 200 Investment Committee 20 Due diligence 3 Docs drafting and 2 closing 48
  • 49. Initial screening process 1 Market Size, growth, major trends, macro drivers, competition level, technologies, industry historical overview, overview seasonality and cyclicality, capacity, concentration level Product What are the product’s characteristics, value added/commodity, key value differences Fragmentation, product positioning, vertical integration, Competitors size and growth rates of competitors, profitability, leverage level, strengths / weaknesses Entry barriers Economies of scale, brand identity, proprietary and substitution technologies, capital requirements, switching costs, threats access to distribution, learning curve, government policy STOP. Is it an attractive industry? Project team discussion. If “yes”, continue 49
  • 50. Initial screening process 2 Management Overall impression, experience, motivation, goals vs. historical team and achievements, what are the hidden agendas and are your shareholders interest aligned • Operations: key business units, cost position, productivity, Company technology, capacity utilization, capex requirements, equipment • Financials: look at the crisis years, top-line growth per business unit, one-time revenue, profitability levels in comparison with the industry, identify money-generating and loss-making units, operating leverage, Capex, WC, tax liabilities, capital structure, debt financing terms, historical performance vs. historical budget, accounting, ROIC, ROE, ROA, break-even, payback period, etc. • Sales/Marketing: brand, product positioning, marketing efficiency, customers acquisition costs, sales efficiency, distribution channels, logistics • Personnel: productivity, turnover, compensation level, earn-outs, parachutes, pension liabilities • Technology/Engineering: IT system, Intellectual property, technological advantage, development skills, product renewals, product pipeline 50
  • 51. Initial screening process 2 Differentiation of inputs, switching costs, substitutes, Suppliers supplier concentration, volume-cost function, integration threats Buyers’ concentration, volumes, switching costs, Customers information, threat of backward integration, substitute products, share in total purchases of the buyer, buyer profits STOP. Is it an attractive target? Project team discussion. If “yes”, continue 51
  • 52. Initial screening process 3 • Fund uses: construction, marketing, m&a etc. Build • Forecasted efficiency of fund uses vs. historical: focus on business case ROE, ROIC for the project in comparison with historical data and industry standards Comparables • Create comparables set in order to understand valuation metrics • Identify key value drivers. Understand possible Financial improvements, issues model • Build several scenarios • Model UFG returns • Identify list of potential buyers and reasons for the interest Exit scenarios • Protect Fund position: put option, ratchet mechanisms, Deal structure accelerated put, liquidation preference, drag/tag along, • Add a sweetener: upside sharing, call option STOP. Prepare presentation for team discussion 52
  • 53. Russian PE/VC landscape 53
  • 54. Russian PE industry landscape Institutional funds Captive funds Government- Family offices backed 54
  • 55. Russian VC industry landscape International funds Russian funds Accelerators Government- backed 55
  • 56. Russian vs Foreign PE industry 56
  • 57. Russian vs Foreign PE sector performance EBRD PE Portfolio Cambridge EM VC&PE One year Index Five years Ten years EBRD Russia/CIS PE portfolio 0% 5% 10% 15% 20% 25% 30% Source: Cambridge Associates, EVCA/ Thomson Reuters, Bloomberg and EBRD 57
  • 58. Emerging market PE investments by region Source: Bain 58
  • 59. Difficulties for LBO deals in Russia In global: debt financing of PE deals is about 55% In Russia: debt financing is less than 20%  Very few mezzanine funds operates in Russia  Central bank set strict limits for such deals (high reserves, advance requirements for capital) for local banks  Prudent approach in apprising pledge  Off-shore payments  High inflation rate (so high bank`s credit rates)  Still high return opportunities for equity investments 59
  • 60. Entry strategies of PE investments 60
  • 61. Entry strategies. Overview Target Stake Deal Deal Fund’s Type of company acquired structure funding strategy fund stage Classical Current PE funds, Growth/ Debt/Self Buy and Buyouts Mature >50% shareholders financed build cash out mezzanine funds New issued stock Financial Venture Growth/ purchase/current Self investor Growth capital Mature <20% shareholders financed (funds for funds, PE funds partial cash out growth) Financial Venture Development New issued stock Self investor Early/Growth <20% funds, PE capital purchase financed (funds for funds growth) Financial Current Minority Growth/ Self investor Classical <50% shareholders recapitalization Mature financed (funds for PE funds cash out growth Reorganizati Special Distressed Mature/ Debt obligations Self >50%/100% on and situations situations Decline assignment financed restructuring funds 61
  • 62. Entry strategies. Rationale for LBO deals  Tax deductibility of debt interest Cost of  Lower cost of debt if compare with equity capital  Cost of capital reduction as a result of company’s gearing growth  Substantial increase in equity value as a result of relatively small Gearing increase in company’s enterprise value effect  Higher IRR for equity investors as the interest on a debt funding is fixed Cost  High gearing – reduction of company’s cash flow reduction  Management is obliged to focus on driving costs down measures trigger  The problem of excess capex is eliminated  IRR for equity investors has a great upside potential Managemen  Flexible ratchet mechanisms allow managers increases their stake t incentives in circumstances of higher IRR achievement 62
  • 63. Entry strategies. LBO candidates LBO suitable targets Leading market Strong&Stable Low capex position/clear cash flow requirements niche Extensive Margin Strong Clear exit growth increase management strategy opportunities potential Volatile/poor cash flow LBO inconsistent Weak market position/search for a new niche stories Unsuccessful management’s track record Small size 63
  • 64. Entry strategies. Forms of debt funding under LBO deal Most common conditions Lower  Provided by bank/syndicate of banks risk  Secured by firms assets  Structured in up to three tranches: A,B,C Senior debt  Repayment in equal installments  Period ~ 7-10 years  Floating rate of interest (LIBOR + 2-3% )  Looser covenant package as compared with senior debt Subordinated debt  Higher lending costs as compared with senior debt, fixed interest rate  Common form – high yield bonds  High risk subordinated debt (less provision, looser covenants)  Interest include: Mezzanine • Variable rate (LIBOR + 4%) – payable periodically • PIK (4-5%) – roll up into the principal • Equity warrant  Loan stork - notes convertible to equity at a Loan stock/ fixed conversion ratio  Preferred stock – fixed dividend, higher Lower priority preferred stock priority in case of liquidation as compared with ordinary shares
  • 65. Entry strategies. LBO deal basic structure Ownership Investor(s) Senior level (PE fund(s)) Debt Lender investment Equity and debt Loan notes Term loan investment and sharesHolding level Payment of consideration SPV Newco Seller(s) Ownership OwnershipOperational level Sale of shares Target Target Subsidiaries Subsidiaries 65
  • 66. Entry strategies. LBO deal complex structure Ownership Investor(s) Mezzanine Senior level (PE fund(s)) fund Lender Warrant Equity investment Mezzanine Topco1Holding level Loan debt Senior debt 100% Midco1 100% Midco2 Payment of 100% consideration Bidco Seller(s) Ownership OwnershipOperational level Sale of shares Target Target Subsidiaries Subsidiaries 66
  • 67. Entry strategies. Growth and development capital  Minority investments Form and  Most common forms – preferred equity and mezzanine structure  Priority position in the capital structure relative to the common equity owners  Business growth initiative enhancement/maintenance Use of funding  New markets expansion, M&A strategy implementation  No/insignificant cash out for current shareholders  No control on the Board of Directors Corporate  Certain controls on management decision concerning operating governance and capital budgets, M&A strategy, funding attraction, capex program  Certain exit plan requirement – put features (time/performance Exit triggers) opportunities  Defense mechanisms in equity agreements: tag along rights Limited influence on company’s management in exchange for a priority in proceeds distribution and a fixed return from investment 67
  • 68. Entry strategies. Growth capital deal structure New investor Current New investor (PE/mezzanine shareholders (PE fund) fund) Equity growthFunding level capital Ownership Mezzanine growth capital Equity pre-money valuation = $X $Z Use of proceeds M&A, capex Target ($X) $Y $VOperational level program Cash out Growth capital = $Y+V-Z = $Y-Z Equity post-money valuation = $X+Y-Z Enterprise value = $X+Y-Z+V 68
  • 69. Entry strategies. Distressed situations Corporate reorganization Debt restructuring Change of management Entry value creation Contract base Corporate governance extension optimization Synergies with other investors’ companies 69
  • 70. Exit strategies for PE funds 70
  • 71. Exit strategies. Returns on exit Unsuccessful Successful Valuation investment investment Valuation EV on exit Management equity Management equity PE fund equity Redeemable PE fund stock Management equity equity PE fund equity Mezzanine/Su EV on bordinated Redeemable Redeemable exit stock stock notes Mezzanine Mezzanine/Su Mezzanine/Su Senior Senior bordinated bordinated notes notes Debt Debt Time Senior Senior Debt Debt Time 71
  • 72. Exit strategies. Overview  Acquisition of a target by it’s current management Company team size/maturity MBO  Management’s stake before MBO - zero/ insignificant  Example: buyout of a non-core subsidiary  Disagreements on company’s development Sale to other strategy  Dead lock danger shareholder  Spin offs, non cash-deals  Acquisition by a new vehicle created by new PE investor/strategic Secondary buyout investor  The third, forth, etc buyout rounds may also take place  Most IPO proceeds – growth and development capital IPO  Only partial cash out of current shareholders is Likelihood possible of positive target’s performance 72
  • 73. Exit strategies. MBO/MBI deal basic structure Current Equity managers investment (MBO) Investor(s) Investor Senior (PE fund(s)) (PE fund) Debt Lender New managers investment (MBI) Mezzanine and Loan notes Term loan debt investment Equity Previous round investment Payment of investor (“sweety consideration equity”) Newco Seller(s) Ownership Ownership Sale of shares Target Target Subsidiaries Subsidiaries 16 73
  • 74. Exit strategies. Secondary buyout: rationales Rationales for seller and target Rationales for new PE investor  End of the fund life reach  Possibility to obtain more value out of the investment because  Next capital injection is needed in of an exclusive sector expertise order to achieve further growth and etc  Change in investment  Investment in a proven profile/strategy of a fund business carrying stable  Good price and deal conditions dividends flow with a proven proposed by secondary investor management team 74
  • 75. Exit strategies. IPO process Investment Grooming a bank and Due Underwriting company for legal advisor Diligence agreement IPO appointment  The executive  Pre-IPO research –  Full commercial,  Setting out in details management team: educating potential financial, tax, legal the mechanics of the • reliance on current investors about the business inspection fundraising and CEO/CFO investment case  Performed by admission process • change of  Investment independent management presentation – key accounting firm and marketing document for company’s legal  Potential due diligence presenting company’s advisers issues – in-house DD in story to potential order to prepare investors company for a rigorous  Disclosure document – pre-IPO inspection prepared by advisers/key part of a marketing process 75
  • 76. Exit strategies. IPO structure Public PE investor investors Post – IPO  No full exit in an IPO stake Cash-out IPO proceeds  The level of the retained stake depends on the investors demand (fixed cash-in is needed, the Private equity backed extent will result in a company cash-out of current shareholders)  New investors wish the initial investor retains a stake to assure the alignment of their interests Private equity backed New shares stake public offering issue 76
  • 77. Exit strategies. IPO pros and cons IPO advantages IPO disadvantages  Higher exit valuation  Lack of complete exit  Increased liquidity  PE stake to large to be fully sold  Management support  Full cash out - negative message to new investors  Better if IPO cash proceeds are allocated to the company  Timing  Cost and distraction of management’s attention  Info disclosure obligations  Loss of control  Risk of failure  Lock-up 77
  • 78. PE Careers 78
  • 79. PE careers Entry strategy Exit opportunities Partner Unlimited  Work experience in  Top management Investment director Unlimited Private equity positions in industry  Successful completed  Top management deals track record position in fund’s  Recruiters, networking company/project  Own business/project VP/Associate 1-3 Director launch years  Work experience in Big4,  Middle level management IB, Industry is required 1-3 positions in industry  Recruiters, networking Associate/Invest years  Upside position in ment manager smaller fund  Own project launch 1-3 Analyst years  Last year students Internships  Applications on career sites 79