Introduction to private equity (2008)

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Introduction to private equity, presented by James Clarke at the University of Kansas, 2008

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  • Competition on the Street during the buyout boom lead to historically forceful lending standards. Deferred / PIK notes increased as percentage share of PIK toggles/ Alternative High Yield Structures during the 2005 to 2007 period. The distribution by number of covenants has decreased considerably since the late 90s. With this number peaking in the 4Q of 2007 with over 60% of the Covenant numbers being two or less. Additionally, there is a marked increase in the volume of Covenant-Lite Loans, with a volume of $100b in 2007.
  • Introduction to private equity (2008)

    1. 1. Introduction to Private Equity James G. Clarke Director Private Equity Investments Kauffman Foundation
    2. 2. <ul><li>Who am I? </li></ul><ul><li>What is private equity? </li></ul><ul><li>Buyouts and venture </li></ul><ul><li>Market overview </li></ul><ul><li>Career options </li></ul><ul><li>Q&A </li></ul>Agenda
    3. 3. Who am I? <ul><li>Director, Private Equity Investments, Kauffman Foundation (2002 – present) </li></ul><ul><ul><li>>$700 million in private equity fund investments in the U.S., Europe, and Asia </li></ul></ul><ul><li>Founder, Rockhill Partners (2005- present) </li></ul><ul><ul><li>Angel investor in technology and life science companies </li></ul></ul><ul><li>Investment banker with Nations Media Partners (1998 – 2002) </li></ul><ul><li>Co-founder, S&S Communications (1999-2002) </li></ul><ul><li>MBA from the University of Kansas (2004) </li></ul><ul><li>BA from Washburn University (1997) </li></ul>
    4. 4. <ul><li>Who am I? </li></ul><ul><li>What is private equity? </li></ul><ul><li>Buyouts and venture </li></ul><ul><li>Market overview </li></ul><ul><li>Career options </li></ul><ul><li>Q&A </li></ul>Agenda
    5. 5. Definition Private Equity: Private equities are equity securities of unlisted companies . Private equities are illiquid and usually long-term investments . Private equity investments are not subject to the same regulations as securities sold to the general public. Private equity includes two broad classes: Buyouts involve the purchase of an existing company using a combination of debt and equity . Returns are primarily a function of purchasing cheaply/dearly, growing and/or improving the company, the use of leverage and selling cheaply/dearly. Venture capital involves making an equity investment in an immature company in the expectation that the company can grow quickly. Returns are primarily a function of its growth rate, size of its market and the exit environment.
    6. 6. Private equity landscape Source: Credit Agricole, see slide 41 for additional details
    7. 7. Private equity backed companies <ul><li>Venture Capital </li></ul><ul><li>Buyouts </li></ul>
    8. 8. A (really) brief history of private equity <ul><li>American Research and Development </li></ul><ul><ul><li>Founded by Georges Doriot, the “father of venture capital” </li></ul></ul><ul><ul><li>$70,000 invested in 1957 in Digital Equipment Corporation (DEC) returned $355 million after the company's initial public offering in 1968 </li></ul></ul><ul><li>J.H. Whitney was formed in 1946 by the Whitney Family </li></ul><ul><ul><li>One time investment of $5 million (about $54 million today) </li></ul></ul><ul><ul><li>Model followed by several other prominent East Coast families including the </li></ul></ul><ul><li>Whitney accepted outside capital beginning in 1990 </li></ul><ul><li>Bessemer accepted outside investors for the first time in 2007 </li></ul><ul><ul><li>>25 IPOs and >50 M&A exits within the past decade </li></ul></ul>
    9. 9. Why invest in private equity? Source: Cambridge Associates, Q1 2008
    10. 10. Fund structure and organization Source: EVCA
    11. 11. The players <ul><li>General partner (GP) raises, manages and invests the fund </li></ul><ul><ul><li>Typically 4-5 years to invest </li></ul></ul><ul><ul><li>Returns capital within 10 years </li></ul></ul><ul><ul><li>Put up 1% to 5% of the fund’s capital </li></ul></ul><ul><li>Limited partners (LPs) provide >95% of the capital </li></ul><ul><li>GP takes 2% to 2.5% of the fund’s capital base annually as its management fee </li></ul><ul><li>GP earns 20%+ of the fund’s profits; the “carried interest” </li></ul><ul><li>Capital is called as needed, not funded all at once </li></ul>
    12. 12. Private equity is different <ul><li>Really expensive 1 </li></ul><ul><li>Fat tailed distribution 2 </li></ul><ul><li>Persistence of returns 3 </li></ul><ul><li>Leverage, Leverage, Leverage 4 </li></ul><ul><li>A lot of “smart” investors aren’t very good at it 5 </li></ul>1 – Andrew Metrick and Ayako Yasuda, “The Economics of Private Equity Funds,” 2007 2 – “U.S. Venture Capital Investing,” Cambridge Associates, 2006. 3 – Steve Kaplan and Antoinette Schoar, “ Private Equity Performance: Returns, Persistence and Capital Flows,” 2003 4 – See David F. Swensen, Pioneering Portfolio Management , pages 230-234 5 – Josh Lerner, et al, “Smart Institutions, Foolish Choices?: The Limited Partner Performance Puzzle,” 2005
    13. 13. <ul><li>Who am I? </li></ul><ul><li>What is private equity? </li></ul><ul><li>Buyouts and venture </li></ul><ul><li>Market overview </li></ul><ul><li>Career options </li></ul><ul><li>Q&A </li></ul>Agenda
    14. 14. How do buyouts make money? <ul><li>Buy. </li></ul><ul><li>Lever. </li></ul><ul><li>Improve. </li></ul><ul><li>Exit. </li></ul><ul><li>When in doubt, lever it up! </li></ul><ul><li>Responsible for 41% of buyout returns between 1986 and 1990 </li></ul><ul><li>Fell to 24% in 1996 to 2000 study </li></ul><ul><li>Biggest factor between 2003 and 2007 </li></ul><ul><li>Operational Improvements </li></ul><ul><li>34% of return between 1986 and 1990 </li></ul><ul><li>43% of return between 1996 and 2000 </li></ul>Source: Jin Li and Fiona Wang, “Leveraged Buyouts: Inception, Evolution, and Future Trends” Perspectives, Vol 3, No. 6 (Sept. 30, 2002).
    15. 15. Simple LBO example <ul><li>LBO’s are just like buying a house </li></ul><ul><ul><li>Minimal down payment (20% to 30%) </li></ul></ul><ul><ul><li>Significant leverage / debt (70% to 80%) </li></ul></ul><ul><ul><li>Cash flow (your wages / company earnings) must meet debt payments </li></ul></ul><ul><ul><li>Asset (house / company) should increase in value during holding period (home improvements / company is more profitable) </li></ul></ul><ul><ul><li>Minimal initial investment can yield significant gain…especially in an up market </li></ul></ul>
    16. 16. Simple LBO example (cont’d) <ul><li>Buy a house / company for $100 </li></ul><ul><ul><li>Minimal down payment ($20) </li></ul></ul><ul><ul><li>Significant leverage / debt ($80) </li></ul></ul><ul><ul><li>Cash flow (your wages / company earnings) must meet debt payments </li></ul></ul><ul><ul><li>Over three years mortgage / debt payments reduce principal to $75 </li></ul></ul><ul><ul><li>Over 3 years value of the house / company rises to $125 </li></ul></ul><ul><ul><li>Sell company for $125 </li></ul></ul><ul><ul><li>Subtract $75 of debt </li></ul></ul><ul><ul><li>$50 remaining -- $30 gross profit plus $20 originally invested </li></ul></ul><ul><ul><li>80% of profit to LPs -- $24 </li></ul></ul><ul><ul><li>20% of profit to the GP -- $6 </li></ul></ul>
    17. 17. Leverage! <ul><li>Buying house with leverage </li></ul><ul><ul><li>$20 invested to buy $100 house, sold for $125 in 3 years </li></ul></ul><ul><ul><li>$24 net profit to LPs (on $20 invested) </li></ul></ul><ul><ul><li>33% net IRR, 2.2x multiple </li></ul></ul><ul><li>Buying the house without leverage </li></ul><ul><ul><li>$100 invested to buy $100 house, sold for $125 in 3 years </li></ul></ul><ul><ul><li>$20 net profit to LPs (on $100 invested) </li></ul></ul><ul><ul><li>10% net IRR, 1.2x multiple </li></ul></ul><ul><li>Interest costs are tax deductible </li></ul><ul><li>OPM rule </li></ul>
    18. 18. Leverage alone is not the answer Caribbean Restaurants, LLC Sources: All data from public sources including The Lookout from Miradero Capital (Q2 2004) and The Deal , April 18, 2005 1991 Sold 86 stores for $70 million 1994 ~5x return 1996 4x return 1999 2.5x return 2004 Paid $340 million for 165 stores, 174 stores today
    19. 19. Headed for a fall? <ul><li>On March 17, 2008, Standard & Poor's Ratings Services lowered the ratings on Caribbean Restaurants LLC to 'CCC+' from 'B'. </li></ul><ul><li>Definition of CCC: “currently vulnerable and dependent on favorable economic conditions to meet its commitments” </li></ul><ul><li>Highlights of S&P report: </li></ul><ul><ul><li>“ The outlook remains negative.” </li></ul></ul><ul><ul><li>“ The downgrade reflects the distinct possibility that the company will breach financial covenants of its bank facility at its fiscal year-end.” </li></ul></ul><ul><ul><li>“ The ratings on CRI reflect its small size in the competitive quick-service restaurant sector, its narrow geographic focus which leaves the company susceptible to changes in the Puerto.” </li></ul></ul>
    20. 20. Simple venture example <ul><li>Venture capital is a little (lot?) like gambling </li></ul><ul><ul><li>Identify promising technology </li></ul></ul><ul><ul><li>Invest relatively few dollars ($1-$5 million) for 25%+ of the company) </li></ul></ul><ul><ul><li>Work with founders to </li></ul></ul><ul><ul><ul><li>Define strategy </li></ul></ul></ul><ul><ul><ul><li>Improve product/service </li></ul></ul></ul><ul><ul><ul><li>Access key early customers </li></ul></ul></ul><ul><ul><ul><li>Make key hires </li></ul></ul></ul><ul><ul><li>Guide fundraising in additional rounds of capital to fund additional growth and development </li></ul></ul><ul><ul><li>Sell or take company public (IPO) </li></ul></ul>
    21. 21. <ul><li>Who am I? </li></ul><ul><li>What is private equity? </li></ul><ul><li>Buyouts and venture </li></ul><ul><li>Market overview </li></ul><ul><li>Career options </li></ul><ul><li>Q&A </li></ul>Agenda
    22. 22. Market Review <ul><li>“ Never underestimate the power of </li></ul><ul><li>stupid people in large groups.” </li></ul>Source: Despair.com
    23. 23. Ripped from the headlines… <ul><li>Texas Pacific Group (TPG) led $7 billion equity infusion in April 2008 </li></ul><ul><li>TPG lost about $1.35 billion of its investors’ capital </li></ul><ul><li>39 buyout-backed bankruptcies YTD…how many more to follow? </li></ul>WaMu is Seized, Sold Off to J.P. Morgan, In Largest Failure in U.S. Banking History – Friday, September 26, 2008
    24. 24. Buyouts raised record $’s in 2005, 2006 & 2007 $ in billions Source: Dow Jones Private Equity Analyst as of August 2008
    25. 25. 9 of 10 Largest Deals Ever Occurred in 2005-07 Source: Andrew Ross Sorkin, New York Times Dealbook, February 26, 2007 citing Dealogic data
    26. 26. Money to Burn?
    27. 27. Too hot? …ratio of capital raised to invested Source: Venture Economics, U.S. buyouts only
    28. 28. Déjà vu all over again? Source: Financial Research Corp - 2001 data through Nov. 30.
    29. 29. Buyout returns likely to disappoint <ul><li>Entry multiple 10.0x </li></ul><ul><li>Debt multiple 6.5x </li></ul><ul><li>Growth rate 5.0% </li></ul><ul><li>Exit Multiple 7.0x </li></ul><ul><li>Gross IRR 11.5% </li></ul><ul><li>Less Fees and Carried Interest </li></ul><ul><li>Net IRR 9.8% </li></ul>Source: EMKF model, assumes a 5 year holding period, 2% management fee and 20% carried interest The Dirty Truth: From 1982 to 2002 buyout funds over $1 billion in size generated an average return of just 5.5% 9.8% could be optimistic!
    30. 30. Venture fundraising rebounding $ in billions Sources:Dow Jones Private Equity Analyst as of August 2008
    31. 31. Cleantech investing is hot Source: Cleantech Group, January 2008
    32. 32. Emerging market fundraising 2007 2006 2004 2003 2005 Emerging Asia ($Bn) 2005 2004 2003 2006 2007 C. & E. Europe / Russia ($Bn) 2006 2003 2004 2005 2007 Latin America ($Bn) 2003 2004 2005 2006 2007 Middle East & Africa ($Bn) 11.4 Source: EMPEA
    33. 33. <ul><li>Who am I? </li></ul><ul><li>What is private equity? </li></ul><ul><li>Buyouts and venture </li></ul><ul><li>Market overview </li></ul><ul><li>Career options </li></ul><ul><li>Q&A </li></ul>Agenda
    34. 34. A career in private equity?
    35. 35. Considering a career in private equity? <ul><li>Rarely boring </li></ul><ul><li>Play with the big dogs </li></ul><ul><li>Work with really smart people </li></ul><ul><li>Chance for significant responsibility early in your career </li></ul><ul><li>Industry expertise or breadth of knowledge across industries </li></ul><ul><li>Chance to make a lot of money </li></ul><ul><li>Hours can be brutal </li></ul><ul><li>Big dogs sometimes bite </li></ul><ul><li>Smart people aren’t always so much fun </li></ul><ul><li>Hours/days/years spent doing seemingly menial tasks </li></ul><ul><li>Specialization can lead to obsolescence </li></ul><ul><li>Generalists are a dime a dozen </li></ul>Pros Cons <ul><li>Money doesn’t buy happiness </li></ul>
    36. 36. Common routes to a job in private equity <ul><li>Venture capital </li></ul><ul><ul><li>Successful entrepreneurs </li></ul></ul><ul><ul><li>Scientists/Physicians (MD, PhD, etc.) </li></ul></ul><ul><ul><li>Consultants </li></ul></ul><ul><li>Buyouts </li></ul><ul><ul><li>Senior executives and proven operators </li></ul></ul><ul><ul><li>Investment bankers </li></ul></ul><ul><ul><li>Consultants </li></ul></ul><ul><li>Pedigrees matter </li></ul><ul><ul><li>Ivy league schools, McKinsey and Bain consultants, major Wall Street banks </li></ul></ul>
    37. 37. Uncommon but common route to private equity <ul><li>Hometown: Hesston, Kansas </li></ul><ul><li>First job: bailing hay on family farm </li></ul><ul><li>Undergrad: BA - Washburn University </li></ul><ul><li>First job after college: Accountant - Pricewaterhouse Coopers </li></ul><ul><li>Graduate degree: MBA - Harvard Business School </li></ul><ul><li>First job after MBA: Consultant – Bain & Co. </li></ul><ul><li>Other positions: CEO of PWC Consulting; President & COO of Continental Airlines; CEO of Burger King; CEO of Quiznos </li></ul><ul><li>Current position: Chairman - CCMP Capital </li></ul>Q: How did you go from tiny Washburn University in Topeka, Kansas, to Harvard Business School? A: The reason I got in was because I was from the middle of nowhere, and they were trying to diversify. The first day, we went around the room telling everybody where we were from. I was thinking that if half of what everyone was saying was true, the economy would shut down from an overload of grandiose BS. I had my cowboy boots on at the time, so when it was my turn, I put my boots up on the desk and said, &quot;It's getting pretty deep in here.'' That broke the ice. Sources: quote from Jungle magazine, May 1, 2001, other information from BusinessWeek (Nov 8, 2004) and CCMP Capital
    38. 38. Recommended reading and viewing <ul><li>Private Equity and Venture Capital: </li></ul><ul><li>The Venture Capital Cycle , Gompers and Lerner, 2006 </li></ul><ul><li>Venture Capital and Private Equity Casebook , Lerner et al, 2008 </li></ul><ul><li>The Art of the Start , Guy Kawasaki, 2004 </li></ul><ul><li>Valley Boy: The Education of Tom Perkins , Tom Perkins, 2007 </li></ul><ul><li>Deals from Hell , Robert Bruner, 2005 </li></ul><ul><li>Founders at Work , Jessica Livingston, 2007 </li></ul><ul><li>Anti-Portfolio at www.bvp.com </li></ul><ul><li>Institutional Investing: </li></ul><ul><li>Pioneering Portfolio Management , David Swensen, 2000 </li></ul><ul><li>Hedghogging, Barton Biggs, 2006 </li></ul><ul><li>When Markets Collide , Mohammed El-Erian, 2008 </li></ul><ul><li>General Investing & Philosophy: </li></ul><ul><li>The Millionaire Next Door , Stanley and Danko, 1998 </li></ul><ul><li>When Genius Failed, Roger Lowenstein, 1998 </li></ul><ul><li>Ahead of the Curve , Philip Delves Broughton, 2008 </li></ul><ul><li>Liars Poker , Michael Lewis, 1990 </li></ul><ul><li>No Asshole Rule , Robert Sutton, 2007 </li></ul><ul><li>Watch: </li></ul><ul><li>Barbarians at the Gate </li></ul><ul><li>Pirates of Silicon Valley </li></ul>The Entrepreneurial Imperative Carl Schramm, 2006 Good Capitalism, Bad Capitalism Schramm, et al 2007 A word from our sponsor:
    39. 39. <ul><li>Questions? </li></ul><ul><li>[email_address] </li></ul>
    40. 40. <ul><li>Appendix </li></ul>
    41. 41. Private equity landscape
    42. 42. Changing Landscape Covenant-Lite Volume Equity Contribution of Leveraged Buyouts Source: S&P Leveraged Lending Review 2Q08. Source: S&P Leveraged Lending Review 2Q08. <ul><ul><li>($ in billions) </li></ul></ul>Going forward, buyout deals will rationalize with more covenants, higher equity contributions and lower debt ratios. Source: S&P Leveraged Lending Review 2Q08. Debt/EBITDA Ratios for LBO Loans Slide adapted from Credit Suisse, October 9, 2008
    43. 43. Both Leverage and Prices Are Dropping Average debt as a multiple of EBITDA Average price as a multiple of EBITDA <ul><ul><li>(Price/EBITDA of issuers with EBITDA of more than $50 million) </li></ul></ul><ul><ul><li>(TEV/EBITDA of transactions with EBITDA of more than $50 million) </li></ul></ul>Source: Standard & Poor’s US LBO commentary as of June 30, 2008. Avg. 4.9x Avg. 7.8x Slide adapted from Credit Suisse, October 9, 2008
    44. 44. Skill-set scorecard Credit: Inspired by Scott Stallings, Wharton School, University of Pennsylvania, August 2006 with modifications by the author Entrepre-neurship Finance Accting Raw Genius Industry Knowledge Judgment Leader-ship Pedigree; Education Team Player Capital Markets              Strategy Consulting                Corporate Finance                    Hedge Funds                    General Mgmt                  Investment Mgmt                  Private Equity                        Venture Capital                        

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