ISSUES IN PRIVATE
    EQUITY FUNDS
      TERESA BARGER
PRIVATE EQUITY AND INVESTMENT FUNDS
INTERNATIONAL FINANCE CORPORATI...
2


        What is a Private Equity Fund?
♦ Up-front commitment of capital for future
    investments.
♦   Collective inv...
3


     Capital Base Overtime
                                 -- - -    Committed amount

                              ...
4


            Fee: Commitments

100
 100

60
 60



                         44                            10
          ...
5


        Fees Fall Over Time

Fees
 Fees
 $$




        00               10
                          10
6

How Can Manager Keep Teams
        Together?
      Only teams with a good track record can raise
                    fo...
7

   In the Go-Go days, the half life of US -
      Venture Capital Funds was short.
    In the Emerging Markets, it is l...
8

             J Curve
      Cash on Cash Patterns
     IRRs typically do not turn positive until there
           are re...
9
                J Curve
         Cash on Cash Patterns
     For valuations, IFC needs to look at the Fair Market Value
 ...
10
                What is difference between
                    Venture Capital
                            and
        ...
11


     What is the Investment Thesis?
  Private Equity: making the world safe for
                  strategic investors...
12

              Investment Thesis
               Venture Capital


Idea / Seed   Friends,                    Later      ...
Generic Private Equity Deal Types                                                           13

                   (typica...
14
          Building Blocks of Private Equity (I)
                       Deal Flow

             Basic question          ...
15

         Building Blocks of Private Equity (II)

                          Basic question                             ...
16


Impact of possible emerging market constraints: IRR & cash multiple
                     before fees. Illustrative on...
17
                “Persistency”
In private equity, the spread between top performers and average performers is large.
   ...
18

   “Persistency”- Success in Private
     Equity is not Luck, it is Skill.

Mc Kinsey finding in Europe:
“If your firs...
19
              Matching the Business Plan & the GP (example)
   General concept:                                        ...
20
                                Investment Process
            For venture capital, can take 2-6 weeks from deal alert....
21


                  Net & Gross IRR
Gross      Fees


                     Expenses                      Cash
         ...
22

   We need managers who are
    hungry for NET IRR !
Ø Should eat sandwiches on fees and caviar on
  carry
Ø Should be...
23

Try Not to Pay “Fee – on – Fee”
   Committed & Outstanding




   2%




   00                        10
             ...
24


      “Fee-on-Fee”: Solutions?
1.   Make 2 commitments:
     a. $100 for capital
     b. $ 14 for fees and expenses
 ...
25


               Carry Waterfall
A.   Deal-by-deal (not common in developed markets, but
     found often in emerging m...
26
             Main Terms & Conditions
               TERM                                       REMARKS
Life of Fund (8,...
27
                  TERM                                              REMARKS
Firing the manager                         ...
28

             TERM                                        REMARKS

Distributions: immediate             Send all money ...
Thank you!
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Issues in Private Equity Funds20-11-02

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Issues in Private Equity Funds20-11-02

  1. 1. ISSUES IN PRIVATE EQUITY FUNDS TERESA BARGER PRIVATE EQUITY AND INVESTMENT FUNDS INTERNATIONAL FINANCE CORPORATION
  2. 2. 2 What is a Private Equity Fund? ♦ Up-front commitment of capital for future investments. ♦ Collective investment vehicle ♦ Defined life (10 years is standard; IFC likes shorter) ♦ Professional fund manager / GP ♦ Management fees to cover costs (2% is standard) ♦ Incentive for manager: Carried interest (usually 20% after a hurdle rate of 6 – 10%)
  3. 3. 3 Capital Base Overtime -- - - Committed amount ______ Invested amount $$ 00 44 55 10 10 Commitment Divestment Period Period
  4. 4. 4 Fee: Commitments 100 100 60 60 44 10 10 2% of committed 2% of invested capital capital outstanding
  5. 5. 5 Fees Fall Over Time Fees Fees $$ 00 10 10
  6. 6. 6 How Can Manager Keep Teams Together? Only teams with a good track record can raise follow-on funds Fees Fees $$ Fund 1 Fund 2 Fund 3 00 10 10 20 20 30 30
  7. 7. 7 In the Go-Go days, the half life of US - Venture Capital Funds was short. In the Emerging Markets, it is longer. EM P.E. U.S. V.C. 00 10 10
  8. 8. 8 J Curve Cash on Cash Patterns IRRs typically do not turn positive until there are realizations and distributions. 00 00 55 10 10
  9. 9. 9 J Curve Cash on Cash Patterns For valuations, IFC needs to look at the Fair Market Value For valuations, IFC needs to look at the Fair Market Value at any point in time. at any point in time. FMV 00 00 55 10 10
  10. 10. 10 What is difference between Venture Capital and Private Equity? VC PE Seed Early Development Buy Out Pre -IPO IPO / Stage Capital Strategic Sale
  11. 11. 11 What is the Investment Thesis? Private Equity: making the world safe for strategic investors. Individual / Financial Investors Strategic Investor Family Ø Adds value Ø Main take-out route for the Ø Professionalizes financial Ø May change Management investor Ø May merge Ø Seeks to build a company with large market share, valuable products, customer franchise, etc. (IPOs are rare)
  12. 12. 12 Investment Thesis Venture Capital Idea / Seed Friends, Later Sale / IPO Family & Rounds of Fools Financing (angels) Ø High growth. Ø Exceptional product / Intellectual Property Ø Need weekly & monthly board meetings; close monitoring
  13. 13. Generic Private Equity Deal Types 13 (typical deals are a blend of several of these) (typical deals are a blend of several of these) Type Source of profit Discussion Pricing multiple differential between Simple arbitrage is rare in EMs due to Arbitrage private market and public/M&A inefficient markets. Investment banks markets. best positioned to spot it. Leverage a company with stable Requires a stable environment, low real Leverage earnings. interest rates and access to debt. Increase earnings through expansion or Requires quality corporate management Earnings growth acquisition. and stable/growing economy. Increased profits via improved Requires quality corporate management Margin Expansion efficiency or shifting product into and flexibility of labor and capital. higher-margin niche. Earnings attract a higher price. Company attracts more buyers as it is Improved transparency easier to understand and buyers have and governance more protection. Do via improved accounting and reporting standards and greater minority rights. Earnings of company attract a higher Company reaches a size at which it is a Multiple expansion due to price. viable IPO candidate or attractive M&A growth or profits. target; or high expectations of future profit growth are built into pricing..
  14. 14. 14 Building Blocks of Private Equity (I) Deal Flow Basic question Discussion Is it possible to obtain Private equity relies on control in order to make Control control through either required operating changes and strategic majority positions or decisions. shareholder agreements? Can you buy things that Exits are easier for companies large enough to Exit you can re-sell? list; larger companies with attractive market share; companies with high expected profit growth. Minority stakes in unlisted companies are very difficult to sell. Drag-along and tag-along rights are useful but need to be enforceable. Is there enough growth Growth, or high expectations of growth, create Growth potential to create an exit? exits. Simple concepts are backable in large economies as they can grow to listed company scale, while the same concept in a smaller economy will plateau at family company size.
  15. 15. 15 Building Blocks of Private Equity (II) Basic question Discussion Will the buyer be secure in In many countries title to land and other property is not Property rights ownership? Is ownership clear and clear. You improve a company – and then someone claims easily transferred? Enforceable? it as theirs! Poor contract enforceability undermines private equity. Can you really understand what is Are accounts transparent and reliable? Transparency going on? Are relationships with suppliers and buyers arms -length? Capital controls? Regulation Tax? Foreign purchase of assets? Is both term debt and working Lack of debt finance has a negative impact on private Financial capital available? Are different equity returns. structuring classes and structures of capital Lack of flexibility in structuring may hinder debt-based recognized? strategies to exit and structure risk. Can you get good management to Good management is key to any strategy relying on Managerial talent implement your strategy? growth or margin expansion. US GPs have stables of on- call managers. In emerging markets quality management is at a premium.
  16. 16. 16 Impact of possible emerging market constraints: IRR & cash multiple before fees. Illustrative only. 40.00% 5 35.00% 4.5 4 30.00% 3.5 cash multiple 25.00% 3 IRR 20.00% 2.5 15.00% 2 1.5 10.00% 1 5.00% 0.5 0.00% 0 Developed Longer to Less Higher Less More Slower Devaluation market exit leverage nominal multiple earnings earnings interest expansion needed to growth IRR finance working Cash multiple capital
  17. 17. 17 “Persistency” In private equity, the spread between top performers and average performers is large. If you are not with a top fund manager, you would do better investing in bonds.
  18. 18. 18 “Persistency”- Success in Private Equity is not Luck, it is Skill. Mc Kinsey finding in Europe: “If your first fund was top quartile, there is a 45% chance your next fund will also be top 25% and a 73% chance it will be top half. A new fund management team has a 16% chance of being in the top quartile. Success in private equity is persistent.” Conor Kehoe, Partner McKinsey & Co., EVCA, June 13, 2001
  19. 19. 19 Matching the Business Plan & the GP (example) General concept: Relevant previous No ‘need for restructuring’ STOP experience? Track record? Do sellers face No No enough pressure Deal Flow? STOP Access to deal flow? to accept dilution? No Are the rights of No Ability to identify STOP different tiers of Deal Flow? exits? capital clearly defined? No Understand local Can shareholder STOP unless can buy STOP No conditions: legal, agreements be enforced? majorities family connections? No Are there exits for the STOP No Ability to negotiate & type of deal available? STOP structure locally? Are management talent, No Ability to source debt, No leverage & other factors Can GP STOP No management & other required to extract STOP Find it? factors necessary to Value available? extract value? GO! Yes Yes
  20. 20. 20 Investment Process For venture capital, can take 2-6 weeks from deal alert. Create Get Deal 1st. Screen Deal Alert Preliminary Formal write Investment awareness Flow for deals or actual due up for decision Committee of PE diligence Ø Contacts Ø Must fit 1 page write Can be all up to inform internal or Ø I Banks & objectives colleagues internal & accountants Ø Feel for external Ø Own network economies Ø Seminars Ø Cold Calling Final diligence I.C. sign off if Final Closing and necessary Documents documentation THEN Value Addition and Divestment
  21. 21. 21 Net & Gross IRR Gross Fees Expenses Cash Mgmt Net 29 % 3% Ø Auditing Fees paid Ø Capital calls 9% Management to fund by in advance Ø Board Fee investees Ø Capital Ø Broken returns on a Deal schedule Ø Keep dividends u Need J.I.T
  22. 22. 22 We need managers who are hungry for NET IRR ! Ø Should eat sandwiches on fees and caviar on carry Ø Should be possibility of reaching carry. Ø To increase net: * Invest 120 % of fund (reinvestment w/o fees) * J.I.T. (Just-in-Time) cash management instead of J.I.C. (Just-in-Case) * Get fees from portfolio companies
  23. 23. 23 Try Not to Pay “Fee – on – Fee” Committed & Outstanding 2% 00 10 10 12 12
  24. 24. 24 “Fee-on-Fee”: Solutions? 1. Make 2 commitments: a. $100 for capital b. $ 14 for fees and expenses …but still need IRR on $114 base. 2. After investment period, accrue fee but paid from investment returns …but still paying fee-on-fee in early years. 3. Allow re-investments without fee, with carry …but only want best managers to do this.
  25. 25. 25 Carry Waterfall A. Deal-by-deal (not common in developed markets, but found often in emerging markets) B. Aggregate or full payout (to be encouraged!) 1. Partners get all capital & fees + expenses 2. Partners get 8% compound p.a. (hurdle rate or preferred return) 3. Catch-up on the hurdle goes to fund managers X= 20% (preferred + X) or 25 % of preferred return 4. Then 80 % to LP and 20 % to GP If deal–by–deal, need clawback and escrow
  26. 26. 26 Main Terms & Conditions TERM REMARKS Life of Fund (8, 10 years) Trade off between better IRR and sufficient time to invest and divest Extension of Life - approve annually (eg: 1+1, not 2) - fee should be reduced or zero - Need to emphasize to managers need for quick exits Size of Fund - Minimum size or no go - Maximum size if market is limited GP Commitment Like at least 1% or meaningful personal amount Partnership or Corporate Generally prefer partnership, tax driven Structure Investment Objective Specific but not too narrow Termination Clause - What if market goes bad? - No fault divorce (in partnership) - What % vote - Forced Liquidation - No fault suspension (freeze) Continue
  27. 27. 27 TERM REMARKS Firing the manager -Continue the fund but replace the manager - for cause - Higher % vote required for firing without cause - Vesting schedule for carry - without cause Fees, carry, and hurdle - Budget based fees - Manager should focus on carry Aggregate carry Avoids misaligned incentives of deal–by-deal Investment policy and limitations Also use IFC exclusion list - Max % of fund in 1 company - Max % of fund in 1 country (if the fund’s focus is regional) - Related companies - Size of investment Opt-out Creates problems that need to be dealt with upfront Co-investment policy Can be difficult to match fund’s timing - With carry - Without carry Drawdown based on just-in-time Represses IRR if not just-in-time Continue
  28. 28. 28 TERM REMARKS Distributions: immediate Send all money back in 5 days Re-investments Depends on confidence in GP Organizational expenses Put a cap on it Advisory Board or Board of Require conflicts committee of outsiders Directors and Committees May need audit or valuation committee Investment Committee Does LP want the liability? Key man clause Can suspend new investments until replacement found Follow–on investment funds by same Not until % of first fund is invested (eg: 80%) manager Transfers LPs should have right to transfer Reporting Quarterly, per EVCA & IFC guidelines
  29. 29. Thank you!

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