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Drexel University Lecture - Private Equity Overview
The document provides a comprehensive overview of the private equity landscape, outlining its structure, asset classes, and fund economics. It discusses the current fundraising climate, deal activity, and key metrics for evaluating private equity funds. Additionally, it offers guidelines for identifying attractive assets and creating value within portfolio companies.
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Drexel University Lecture - Private Equity Overview
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- 2. CONFIDENTIAL Agenda Ø Introduction /Background Ø Asset Class Overview Ø Market Overview Ø Private Equity Funds Ø Evaluating Private Equity Funds Ø Questions & Feedback 2
- 3. CONFIDENTIAL Introduction / Background Ø 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 Shuman 215-837-1199 (mobile) justin.shuman@gmail.com 3
- 4. CONFIDENTIAL Objectives Ø Develop ahigh-level understanding of the private equity landscape - Investors - General Partners - Portfolio Companies Ø Establish an elementary understanding of fund economics and how investors make money Ø Walk away with a “tool box” of questions that will help you evaluate private equity funds in the future 4
- 5. CONFIDENTIAL What We areNOT 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 equity Ø Political views and potential legislation surrounding the asset class 5
- 6. CONFIDENTIAL Asset Class Overview Ø 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. CONFIDENTIAL Private Equity ValueChain Ø 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”) FUNDS PE Fund PE Fund PE Fund Fund of Funds INVESTMENTS Venture Growth Equity Buyouts Mezzanine Special Situations Real AssetsDirect Investments Invests in PE Funds 7
- 8. CONFIDENTIAL A Short VocabularyLesson… Limited Partnership Agreement (“LPA”): the agreement that binds LPs to GPs and defines investment strategy as well as all other rules for fund governance Commitment: LP investment in a private equity fund Capital Call: issued by the GP before the closing of a transaction. A capital call requests capital from LPs to fund investment Investment Period: normally 5 years from the fund being “turned on” (i.e. fees commencing and the first capital call). After 5 years the GP may not draw down capital for new investments (“use it or lose it”) Fund Life: usually 10 years Fund Extension: highly negotiated but often 2 year increments to provide more time for the GP to manage and exit existing investments in the fund. Deal-by-Deal: economic calculation that determines carried interest on a deal-by-deal basis (easier to get to the carry early) Back-Ended: economic calculation that determines carried interest on a total fund basis (more difficult to 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 profits IRR: internal rate of return is the discount rate that will bring a series of cash flows to an NPV of 0 Return on Invested Capital (“ROIC”): realized capital / invested capital EBITDA Multiple: purchase price / EBITDA 8
- 9. CONFIDENTIAL Fundraising Climate Ø Significantamounts 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 be invested over the next two to three years Ø 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 $180 2007 2008 2009 2010 2011 2012 CumulativeOverhang OverhangbyYear Cumulative 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 Year Source: Pitchbook. 229 228 275 221 118 113 128 110 0 50 100 150 200 250 300 2005 2006 2007 2008 2009 2010 2011 2012 No.ofFundsRaised U.S. Private Equity Fundraising Source: Pitchbook. 9
- 10. CONFIDENTIAL 33% 21% 13% 12% 9% 8% 4% 34% 20% 13% 14% 6% 7% 5% Business Products& Services Consumer Products & Services Healthcare InformationTechnology Financial Services Energy Materials andResources 0 100 200 300 400 500 600 700 800 900 $0 $50 $100 $150 $200 $250 $300 1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 TotalCapitalInvested Deal Count Private Equity Deal Activity Ø 172 exits took place in 4Q 2012, and the record 6,538 portfolio companies still held will drive future activity Ø Private equity deal flow has been partially supplemented by the record $64.1 billion in dividend recapitalizations in 2012, 58% higher than the previous record of $40.5 billion for the full year 2010 10 Total Private Equity Deal Flow PE Deals by Industry For the Years Ended December 31, 2011 – 2012 Source: Pitchbook. For the Quarters 1Q07– 4Q12 Source: Pitchbook. TransactionVolume ValueofDeals
- 11. CONFIDENTIAL Ø Middle marketM&A transactions (<$500MM) accounted for 91% of private equity deal volume in 2012 as investors exhibited a preference toward smaller deals Ø 49% of private equity capital was allocated to deals below $500 million in 2012, the second highest total since 2005 Ø Since credit market conditions are positive, the proportion of large deals should grow in 2013 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 2005 2006 2007 2008 2009 2010 2011 2012 0-24M 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 2012 0-24M 25M-99M 100M-499M 500M-999M 1B-2.5B 2.5B+ Private Equity Deal Size 11 For Years Ended Dec. 31, 2005 – 2012For Years Ended Dec. 31, 2005 – 2012 Percentage of PE Transactions (Count) by Size Percentage of PE Investment by Deal Size Source: Pitchbook.Source: Pitchbook.
- 12. CONFIDENTIAL Economics Ø LP ManagementFee - 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 fund expenses - Any “excess” fees not used at the end of the year are normally paid out in bonuses to deal team members and divided among the partnership Ø Carried Interest - Incentive payment for successful transactions that exceed hurdle requirements • Normally 8% hurdle rates (management fee, invested capital, and other fees are taken into this calculation) - The fund is entitled to 20% of profits in excess of the hurdle Ø Company Management Fee - Funds often charge their portfolio companies a percentage of EBITDA as a management fee 12
- 13. CONFIDENTIAL Finding Attractive Assets Ø 80 deals are reviewed on average for every 1 investment Ø Funds use a myriad of filters to sort through deal-flow to identify potential investments ü Strong and stable cash flow (EBITDA – CAPEX) ü Strong management ü Low maintenance and growth CAPEX requirements ü Growing end-markets ü High barriers to entry ü Potential for margin improvement and cost reduction ü Acquisition opportunities ü Logical path to exit in 4-7 years 13
- 14. CONFIDENTIAL Financing the Deal Ø 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 fund Ø 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” amortization 14
- 15. CONFIDENTIAL Creating Value Ø Fundspull many levers to create values for their LPs ü Professionalize management, accounting & control systems ü Adjust firm strategy and rationalize product lines, workforce, etc ü Debt can increase firm value if you can afford it! (Exploits corporate aversion to debt) ü Regulatory Arbitrage – Sarbanes-Oxley ü “Bolt-on” acquisitions Ø Robust company performance can lead to dividend recaps as early as years 2 and 3 - Used normally when sale prospects are less than optimal 15
- 16. CONFIDENTIAL Exiting: 4-7 YearsLater… 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 purchasers Ø “Winning” bank conducts a sale process - Broad: show the deal to hundreds of potential buyers - Narrow: show the deal to the most likely potential buyers 16
- 17. CONFIDENTIAL Evaluating Fund Managers Ø 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 control upgrades, manufacturing best practices, customer/workforce rationalization - Financial engineering (debt pay-down) – NO private equity fund will ever market that they are using financial engineering to generate returns - “Roll-up” – purchase a platform business from which a large company will be built through acquisitions Ø Track Record - How many deals have <1.0x ROIC? – What missteps occurred? Has the fund learned from mistakes? - Is the fund executing deals outside of its historical strategy? – New industries than in the past…larger deals than in the past….etc. 17
- 18. CONFIDENTIAL Recommended Books &Websites Ø Books - “Applied Mergers & Acquisitions” – Robert F. Bruner - “Investment Banking: Valuation, Leverage Buyouts, and Mergers & Acquisitions” – Joshua Rosenbaum and Joshua Pearl Ø Websites - www.prequin.com - www.pehub.com - www.pitchbook.com - www.thedeal.com - www.dealbook.com - www.altassets.com - www.bloggingbuyouts.com 18