Drexel University Lecture - Private Equity Overview


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A high level overview of the private equity market, how fund economics work, and what questions to ask general partners when evaluating fund investment merit.

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Drexel University Lecture - Private Equity Overview

  1. 1. CONFIDENTIALUnderstanding Private EquityApril 17, 20131
  2. 2. CONFIDENTIALAgendaØ  Introduction / BackgroundØ  Asset Class OverviewØ  Market OverviewØ  Private Equity FundsØ  Evaluating Private Equity FundsØ  Questions & Feedback2
  3. 3. CONFIDENTIALIntroduction / BackgroundØ  Justin Shuman-  Drexel University (2002 – 2007)-  DuPont Capital Management Private Markets Group Analyst (2007 – 2009)-  Cornell MBA (2009 – 2011)-  Sterling Partners Associate (Summer 2010)-  Harris Williams & Co. Associate (2011 – 2013)Feel Free to Contact Me:Justin Shuman215-837-1199 (mobile)justin.shuman@gmail.com3
  4. 4. CONFIDENTIALObjectivesØ  Develop a high-level understanding of the private equity landscape-  Investors-  General Partners-  Portfolio CompaniesØ  Establish an elementary understanding of fund economics and how investors makemoneyØ  Walk away with a “tool box” of questions that will help you evaluate private equityfunds in the future4
  5. 5. CONFIDENTIALWhat We are NOT Going to Focus on..Ø  Mechanics of an LBO and academic financial explanations:ROE = (Profit Margin )* (Asset Turnover)*(Equity Multiplier)Ø  Finding a job in private equityØ  Political views and potential legislation surrounding the asset class5
  6. 6. CONFIDENTIALAsset Class OverviewØ  Private Equity–  Capital that is invested in private and illiquid securities•  Leverage Buyouts (“LBOs”) – most common•  Venture Capital–  Seed–  Early-Stage–  Late-Stage–  Growth•  Mezzanine•  Real Estate•  Distressed Debt•  Secondary – the purchase of interests in all described herein•  Other – Mortgages, Real Assets (timber, toll roads, infrastructure)6
  7. 7. CONFIDENTIALPrivate Equity Value ChainØ  Value Chain-  Investors commit capital to funds, fund-of-funds, or directly invest in assets-  Funds deploy capital into assets on behalf of their investors (LPs or Fund-of-Funds)-  Investments receive capital from LPs, Funds, and Fund-of-Funds- Pension Funds- Endowments- Foundations- Bank Holding Companies- High-Net-Worth Individuals- Insurance Companies- Investment Banks- Corporations- Other…INVESTORS (“LPs”) FUNDSPE FundPE FundPE FundFund of FundsINVESTMENTSVentureGrowth EquityBuyoutsMezzanineSpecial SituationsReal AssetsDirect InvestmentsInvests in PE Funds7
  8. 8. CONFIDENTIALA Short Vocabulary Lesson…Limited Partnership Agreement (“LPA”): the agreement that binds LPs to GPs and defines investmentstrategy as well as all other rules for fund governanceCommitment: LP investment in a private equity fundCapital Call: issued by the GP before the closing of a transaction. A capital call requests capital fromLPs to fund investmentInvestment Period: normally 5 years from the fund being “turned on” (i.e. fees commencing and thefirst capital call). After 5 years the GP may not draw down capital for new investments (“use it orlose it”)Fund Life: usually 10 yearsFund Extension: highly negotiated but often 2 year increments to provide more time for the GP tomanage and exit existing investments in the fund.Deal-by-Deal: economic calculation that determines carried interest on a deal-by-deal basis (easier to getto the carry early)Back-Ended: economic calculation that determines carried interest on a total fund basis (more difficultto get to the carry early)Hurdle Rate: the IRR hurdle which a GP must earn for LPs before it can begin to take 20% of the profitsIRR: internal rate of return is the discount rate that will bring a series of cash flows to an NPV of 0Return on Invested Capital (“ROIC”): realized capital / invested capitalEBITDA Multiple: purchase price / EBITDA8
  9. 9. CONFIDENTIALFundraising ClimateØ  Significant amounts of private equity raised before the downturn created buying power–  Moving further into an investment period heightens pressure to invest–  Assuming a five-year investment horizon, $141 billion of private equity’s $348 billion of dry powder will need to beinvested over the next two to three yearsØ  Given the capital overhang, fundraising has proven challenging since 2008–  With 805 funds currently in the market, time from initiation to final close is proving longer than 2005 – 2008.–  Fundraising in 2012 fell to the lowest level seen in more than a decade, but the amount of capital raised increased 13%from 2011 as larger funds found the most success$428$501 $481$433$373$348$0$100$200$300$400$500$600$0$20$40$60$80$100$120$140$160$1802007 2008 2009 2010 2011 2012CumulativeOverhangOverhangbyYearCumulative Overhang Under $100M $100M - $250M $250M - $500M$500M - $1B $1B - $5B $5B +For the Years Ended December 31, 2007 – 2012($ in billions)Capital Overhang of U.S. PE Investors by Vintage YearSource: Pitchbook.229 228275221118 1131281100501001502002503002005 2006 2007 2008 2009 2010 2011 2012No.ofFundsRaisedU.S. Private Equity FundraisingSource: Pitchbook.9
  10. 10. CONFIDENTIAL33%21%13%12%9%8%4% 34%20%13%14%6%7%5%Business Products & Services Consumer Products & ServicesHealthcare InformationTechnologyFinancial Services EnergyMaterials andResources0100200300400500600700800900$0$50$100$150$200$250$3001Q072Q073Q074Q071Q082Q083Q084Q081Q092Q093Q094Q091Q102Q103Q104Q101Q112Q113Q114Q111Q122Q123Q124Q12TotalCapitalInvested Deal CountPrivate Equity Deal ActivityØ  172 exits took place in 4Q 2012, and the record 6,538 portfolio companies still held will drive futureactivityØ  Private equity deal flow has been partially supplemented by the record $64.1 billion in dividendrecapitalizations in 2012, 58% higher than the previous record of $40.5 billion for the full year 201010Total Private Equity Deal Flow PE Deals by IndustryFor the Years Ended December 31, 2011 – 2012Source: Pitchbook.For the Quarters 1Q07– 4Q12Source: Pitchbook.TransactionVolumeValueofDeals
  11. 11. CONFIDENTIALØ  Middle market M&A transactions (<$500MM) accounted for 91% of private equity deal volume in2012 as investors exhibited a preference toward smaller dealsØ  49% of private equity capital was allocated to deals below $500 million in 2012, the second highesttotal since 2005Ø  Since credit market conditions are positive, the proportion of large deals should grow in 20130%10%20%30%40%50%60%70%80%90%100%2005 2006 2007 2008 2009 2010 2011 20120-24M 25M-99M 100M-499M 500M-999M 1B-2.5B 2.5B+0%10%20%30%40%50%60%70%80%90%100%2005 2006 2007 2008 2009 2010 2011 20120-24M 25M-99M 100M-499M 500M-999M 1B-2.5B 2.5B+Private Equity Deal Size11For Years Ended Dec. 31, 2005 – 2012For Years Ended Dec. 31, 2005 – 2012Percentage of PE Transactions (Count) by Size Percentage of PE Investment by Deal SizeSource: Pitchbook.Source: Pitchbook.
  12. 12. CONFIDENTIALEconomicsØ  LP Management Fee-  LPs agree to pay funds 2% of commitments during the 5 year investment period-  Continue to pay 2% on cost-basis of remaining fund investments-  Management fee pay for deal team members’ salaries, travel, and other fundexpenses-  Any “excess” fees not used at the end of the year are normally paid out inbonuses to deal team members and divided among the partnershipØ  Carried Interest-  Incentive payment for successful transactions that exceed hurdle requirements•  Normally 8% hurdle rates (management fee, invested capital, and otherfees are taken into this calculation)-  The fund is entitled to 20% of profits in excess of the hurdleØ  Company Management Fee-  Funds often charge their portfolio companies a percentage of EBITDA as amanagement fee12
  13. 13. CONFIDENTIALFinding Attractive AssetsØ  80 deals are reviewed on average for every 1 investmentØ  Funds use a myriad of filters to sort through deal-flow to identify potentialinvestmentsü  Strong and stable cash flow (EBITDA – CAPEX)ü  Strong managementü  Low maintenance and growth CAPEX requirementsü  Growing end-marketsü  High barriers to entryü  Potential for margin improvement and cost reductionü  Acquisition opportunitiesü  Logical path to exit in 4-7 years13
  14. 14. CONFIDENTIALFinancing the DealØ  Equity-  Fund: capital call draws down equity from LPs in pro-rata fashion-  Management: existing management usually “rolls” equity-  Co-investors: LPs that directly invest in the equity outside of the fundØ  Debt-  Senior Debt: secured by assets-  Subordinated Debt: unsecured, second lien on assets-  Mezzanine Debt: fills the gap between equity and debt•  14%-16%, PIK, warrants, “bullet” amortization14
  15. 15. CONFIDENTIALCreating ValueØ  Funds pull many levers to create values for their LPsü  Professionalize management, accounting & control systemsü  Adjust firm strategy and rationalize product lines, workforce, etcü  Debt can increase firm value if you can afford it! (Exploits corporateaversion to debt)ü  Regulatory Arbitrage – Sarbanes-Oxleyü  “Bolt-on” acquisitionsØ  Robust company performance can lead to dividend recaps as early as years 2 and 3-  Used normally when sale prospects are less than optimal15
  16. 16. CONFIDENTIALExiting: 4-7 Years Later…Ø  After value has been created over the hold period, it is time to sell the company-  Filter and select 5-7 investment banks to “pitch” a sale process•  Firm credentials•  Industry and positioning thoughts•  Valuation range•  Most likely purchasersØ  “Winning” bank conducts a sale process-  Broad: show the deal to hundreds of potential buyers-  Narrow: show the deal to the most likely potential buyers16
  17. 17. CONFIDENTIALEvaluating Fund ManagersØ  Team-  Does the team have complementary backgrounds? – not just all ex-bankers or ex-consultants-  What qualifies the team to purchase and operate businesses?-  Are there any legal blemishes on any team member’s background?Ø  Strategy-  Industry expertise? What’s the angle?-  Operationally focused – professionalize the business through accounting and controlupgrades, manufacturing best practices, customer/workforce rationalization-  Financial engineering (debt pay-down) – NO private equity fund will ever marketthat they are using financial engineering to generate returns-  “Roll-up” – purchase a platform business from which a large company will be builtthrough acquisitionsØ  Track Record-  How many deals have <1.0x ROIC? – What missteps occurred? Has the fundlearned from mistakes?-  Is the fund executing deals outside of its historical strategy? – New industries thanin the past…larger deals than in the past….etc.17
  18. 18. CONFIDENTIALRecommended Books & WebsitesØ  Books-  “Applied Mergers & Acquisitions” – Robert F. Bruner-  “Investment Banking: Valuation, Leverage Buyouts, and Mergers &Acquisitions” – Joshua Rosenbaum and Joshua PearlØ  Websites-  www.prequin.com-  www.pehub.com-  www.pitchbook.com-  www.thedeal.com-  www.dealbook.com-  www.altassets.com-  www.bloggingbuyouts.com18