--- GIT.IR e-Learning Platform ---
Welcome back.
Moving on to private equity, we shall examine some of the more common strategies related to private
equity.
The risk and return characteristics of private equity and fee structure for PE funds.
Let's jump in.
Private equity generally means investing in privately owned companies or in public companies with the
intent to take them private.
Private equities are usually categorized according to their investment strategy.
They include leveraged buyouts, venture capital and development capital.
Leveraged buyout funds acquire established private companies or publicly listed companies with a significant
percentage of the purchase price financed through debt.
If the target is a publicly listed company, it is taken private after the buyout.
There are two key criteria for a leveraged buyout to work.
Firstly, the target firms should have the potential for increase in value through some combination
of management incentives, restructuring, cost reduction or revenue enhancement.
Two types of elbows are management buyouts in which the existing management team is involved in the
acquisition and will stay to implement the value add measures.
And management by INS in which an external management team will replace the existing management team
to implement the value add measures on the target firm.
The second criteria is debt managing to work out a highly leveraged purchase.
If debt financing is unavailable or costly, elbows are less likely to occur.
The assets of the target company typically serve as the collateral for the debt on the cash flows of
the target company are expected to be sufficient to service the debt.
If the buyout goes through, the debt becomes part of the capital structure of the target company.
Another very common classification of private equity is venture capital.
Venture capital funds invest in companies in the early stages of their development.
The investment often is in the form of equity that can be in convertible preferred shares or convertible
debt.
While the risk of failure is high, returns on successful companies can be very high.
This is often the case when the company has grown to the point where it can be sold to the public via
an IPO.
The companies in which a venture capital fund is invested are referred to as its portfolio companies.
Venture capital fund managers are closely involved in the development of portfolio companies often sitting
on their boards or filling key management roles.
Categorization of venture capital investments is based on the company stage of development terminology
used to identify venture firm investment at different stages of the company's life includes the following.
The formative stage refers to investments made during a firm's earliest period and comprises three distinct
phases.
Angel investing is capital provided at the idea.
Stage funds may be used to transform the idea into a business plan and to assess market potential.
The amount of financing at this stage is typically small and provided by individuals, rather than by
venture capital funds.
Seed stage financing refers to investments made for product development, marketing and market research.
This is typically the stage during which venture capital funds make initial investments through ordinary
or convertible preferred shares.
Early stage financing is provided to companies moving toward operation.
But before commercial production and sales have occurred, the investments are made to fund the initial
production costs and sales expenses.
Later stage refers to the stage where a company already has production and sales and is operating as
a commercial entity.
Investment funds provided at this stage are typically used for expansion of production and increasing
sales through an expanded marketing campaign.
Mezzanine stage financing refers to capital provided to an established company to prepare it for an
IPO.
It is the bridge between the expanding company and becoming a publicly listed company.
Development capital, also called minority equity investing, earns profits from funding, business
growth or restructuring many times.
Minority equity investing is initiated and sought by management of companies who are interested in realizing
earnings from selling a portion of their shares before they're able to go public.
Although this scenario occurs most commonly with private companies, some publicly listed companies
also seek this form of private equity capital.
Such financing is referred to as private investment in public equities.
And these are the corn categories of private equity, regardless of the strategy.
The ultimate goal for a private equity fund is to improve new or underperforming businesses and exit
them at high valuations in a time frame that averages five years.
If the restructuring is successful, the private equity can sell the portfolio company in a number of
ways.
IPO is a well known approach, which involves selling all or some shares of the portfolio company to
the public.
Advantages include potential for the highest price management approval since they are retained.
Publicity for the private equity firm.
And future upside potential, as the private equity firm may choose to remain a large shareholder.
Disadvantages include high transaction costs paid to investment banks and lawyers long lead times.
High disclosure requirements and potential lock up, period, which bars selling shares for a specified
period.
Ideas are usually only appropriate for larger companies with attractive growth profiles.
If a company is not suitable for IPO, a viable alternative is to sell it through a trade sale, which
is to sell to a strategic buyer, such as a competitor.
Benefits of a trade sale include lower transaction costs than an IPO, immediate cash exits for the
private equity fund.
Lower levels of disclosure required and potential for high valuation of the asset because strategic
buyers may be willing to pay more.
Disadvantages include possible lower price than in an IPO, possible opposition by management, lower
attractiveness to employees of the portfolio company and a limited number of potential trade buyers.
Another form of sales similar to trade sales is secondary sales instead of a strategic buyer, this
approach represents a sale to another private equity firm or other group of investors.
If the portfolio company is not ready for sale yet, the private equity firm can extract some cash through
recapitalisation under this strategy, the company issues debt to fund a dividend distribution to equity
holders, which includes the private equity fund.
Recapitalization is not a true exit strategy, as the private equity firm maintains control.
A recapitalization is often a prelude to a later exit.
If the portfolio company fails to do well, the private equity firm may want to write off some assets
to their fair value.
The private equity may also liquidate the entire portfolio company and concentrate on other projects
in its portfolio.
These exit strategies that we have discussed may be pursued individually, combined together or used
for a partial exit strategy.
For example, a private equity fund can sell a portion of a portfolio company to a competitor via a
trade sale and then complete a secondary sale to another private equity firm for the remaining portion.
Based on historical data.
Private equity funds have provided higher return opportunities relative to traditional investments.
This can be attributed to their ability to invest in private companies.
Their influence on portfolio companies operations and their use of leverage.
Besides, private equity returns have less than perfect correlation with those of traditional investments.
So like most other alternative investments, private equity funds can add diversification benefits to
a traditional portfolio.
The standard deviation of private equity returns has been higher than the standard deviation of traditional
assets returns.
They suggest higher risk when investing in private equity.
While these characteristics seem to indicate that private equity is an ideal diversification asset,
some critics seem unconvinced.
As with most other forms of alternative investments, private equity returns data may be overstated
due to survivorship bias and backfill bias.
Refer back to the first lesson for the explanations on these two biases.
Besides, as the portfolio companies are revalued infrequently reported, correlations overturns and
standard deviations of returns may both be biased downward.
This implies that the diversification benefits are overstated and that PE funds are riskier than what's
reported.
Evidence suggests that choosing skilled fund managers is important differences between the returns to
top quartile funds and bottom quartile funds are significant, and their performance rank shows persistence
over time.
Like hedge funds, private equity funds are typically structured as limited partnerships, where outside
investors are limited partners, and the private equity firm, which may manage a number of funds,
is the general partner.
Most private equity firms charge both a management fee and an incentive fee.
The management fees generally range from one to three percent, while the incentive fee is typically
20 percent.
What's unique to private equity is this notion of committed capital.
This is the amount that the LPs have agreed to provide to the Private Equity Fund.
The committed capital remains with the LPs until the private equity fund draws from it for investment
opportunities that it has identified.
Before the committed capital is fully drawn down, a process which typically takes three to five years,
the management fee is based on committed capital, not invested capital.
So, for example, if the committed capital is $10 million and that has drawn $3 million to invest in
a private equity deal, there will still be $7 million remaining in committed capital.
Committed capital that has not yet been drawn down is referred to as dry powder.
Be very clear that the management fee is calculated based on total committed capital of $10 million,
even though not all the money has been invested.
So for example, if the management fee is one percent, the GBS will receive $100000 fee each year.
Do note this important distinction from hedge funds where management fees are based on assets under
management.
So let's say some time later, the GP entered into another private equity deal and draws down the remaining
$7 million of committed capital to invest in it.
Note that after the committed capital is fully invested, the management fees are paid only on the fund's
remaining in the investment vehicle.
Note this word remaining.
As investments are excited, capital is paid back to the investors and they no longer pay fees on that
portion of their investment.
So, for example, let's say the GP first exited Deal A, the original capital of $3 million is returned
to the Yelp's.
From this point, forward management fee is only applicable to the remaining $7 million invested.
Now that we're done with management fees, let us look at incentive fees, which we still assume to
be 20 percent, for our example.
In essence, the incentive fee is based on the profits booked from exiting investments.
Do note that the incentive fee structure for private equity funds are sometimes subject to a hurdle
rate, which we have covered under hedge funds to keep our discussion here simple.
We shouldn't assume that there is no hurdle rate.
The partnership's waterfall refers to the way in which profits from exiting deals are allocated to the
GP and the Alps.
There are two different systems the American waterfall and European waterfall under an American waterfall
arrangement.
Profits are distributed as each deal is excited and shared, according to the partnership agreement.
This is also known as a deal by Deal Waterfall.
So from our example, let's say delay, which has invested capital of $3 million, was sold first at
$4 million.
The profit of $1 million is distributed on an 80 20 split based on the agreed 20 percent incentive fee.
The GP receives $200000 incentives from this deal, and the LP receives a distribution of $3.8 million.
Let's say some time later, Dubai was sold for $6.4 million as the amount committed to the project was
$7 million.
There was a loss of $600000 since there was no profit made.
The GP receives zero incentive fee from this deal.
So in summary, for the entire PE fund, the total profit made was $400000 and the gap took $200000
in incentive fee.
The incentive fee in aggregate is actually 50 percent, much higher than the 20 percent incentive fee
specified in the partnership agreement.
Now, let's see how the European waterfall arrangement differs.
Essentially, the incentive fee is determined based on the aggregate profit for the whole fund, not
on a deal by deal basis.
This is also called a hole of fund waterfall.
So based on 20 percent to the $400000 profit, the incentive fee to the GP should only be $80000.
Implementation wise, the Alps should receive all distributions until they have 100 percent of their
initial investment, plus the hurdle rate, if any.
So for this case, the $4 million from delay should be fully distributed to the Alps first.
Only the proceeds from DELWP should be distributed between the LP and GP to make sure the GP gets 20
percent of the aggregate profit from the fund.
Each of the two arrangements have their own shortcomings for the whole of fund waterfall arrangement.
The GP's may not receive any incentive fee for a long time for the deal by deal waterfall arrangement.
We may end up with a case where their GP ends up with more incentive fees than is agreed on, as in
this case.
A clawback provision allows LP's the right to reclaim parts of the GP's incentive fee if this scenario
plays out.
So for this case, an LP that is subject to the deal by Deal Waterfall Arrangement may be able to reclaim
the extra $120000 fee that the group received from the first deal.
And that concludes this lesson on private equity in our next lesson, we will briefly touch on the other
aspect of private capital that is private debt.
See you again!