Exploring Private Equity

October 29, 2013

1

Introduction

Justin Shuman

– Education:

Drexel University (B.S., Business Administration)

Cornell University (M.B.A., Concentration in Investment Banking)

– Professional Experience:

Woodlawn Partners – Senior Associate (Current)

Harris Williams & Co. – Associate (2011 – 2013)

DuPont Capital Management – Analyst (2007 – 2009)

2

Contact Information

E-mail: justin@woodlawnpartners.com

Private equity definition and overview of the industry

ecosystem including funds, investors, and portfolio

companies

Step-by-step walk through a hypothetical private equity

transaction including sourcing, valuation, and

confirmatory diligence topics

Recommended reference materials for learning more

about valuation, investment banking, and private equity

3

PE Market Overview PE Transaction Recommended Reading

Private Equity Value Chain

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 Assets Direct Investments

Invests in PE Funds

4

PE Market Overview PE Transaction Recommended Reading

A Short Vocabulary Lesson…

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

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PE Market Overview PE Transaction Recommended Reading

Fundraising Climate

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

be invested over the next two to three years

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

Cu

mu

lativ

e O

verh

an

gOv

erh

an

g b

y Y

ea

r

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

. o

f F

un

ds

Ra

ised

U.S. Private Equity Fundraising

Source: Pitchbook.

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PE Market Overview PE Transaction Recommended Reading

33%

21% 13%

12%

9%

8% 4% 34%

20%

13%

14%

6%

7%

5%

Business Products & Services Consumer Products & Services

Healthcare Information Technology

Financial Services Energy

Materials and Resources

0

100

200

300

400

500

600

700

800

900

$0

$50

$100

$150

$200

$250

$300

1Q

07

2Q

07

3Q

07

4Q

07

1Q

08

2Q

08

3Q

08

4Q

08

1Q

09

2Q

09

3Q

09

4Q

09

1Q

10

2Q

10

3Q

10

4Q

10

1Q

11

2Q

11

3Q

11

4Q

11

1Q

12

2Q

12

3Q

12

4Q

12

Total Capital Invested Deal Count

Private Equity Deal Activity

172 exits took place in 4Q 2012, and the record 6,538 portfolio companies still held will drive

future activity

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

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.

Tra

nsa

ction

Volu

me

Valu

e of

Dea

ls

7

PE Market Overview PE Transaction Recommended Reading

Middle market M&A transactions (<$500MM) accounted for 91% of private equity deal volume in

2012 as investors exhibited a preference toward smaller deals

49% of private equity capital was allocated to deals below $500 million in 2012, the second

highest total since 2005

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

For Years Ended Dec. 31, 2005 – 2012 For Years Ended Dec. 31, 2005 – 2012

Percentage of PE Transactions (Count) by Size Percentage of PE Investment by Deal Size

Source: Pitchbook. Source: Pitchbook.

8

PE Market Overview PE Transaction Recommended Reading

1 – 2 Weeks

Conduct

Due

Diligence

/ Arrange

Financing

Negotiate

Purchase

Agreement

Deal Time-Line

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PE Market Overview PE Transaction Recommended Reading

Source Lead

Speak

with

Owner

Indication

of Interest

(“IOI”)

Negotiate

Letter of Intent

(“LOI”)

Close

Transaction

Create

Valuation &

Returns

Model

1 – 2 Weeks 1 Week 1 Week 2 - 4 Weeks 12 – 16 Weeks

1 2 4

TRANSACTIONS TAKE ANYWHERE FROM 5 MONTHS TO 6 MONTHS OR MORE TO CLOSE

3

Sourcing

Traditional Intermediaries

– Investment Banks

– Business Brokers

Proprietary Sources

– Accountants

– Lawyers

– Business Owners

– Trade Associations

10

PE Market Overview PE Transaction Recommended Reading

1

PROPRIETARY DEAL FLOW NORMALLY EQUALS BETTER/CHEAPER PURCHASE PRICES

Valuation & Return Analysis

DCF

– Use management’s assumptions (revenue growth, profit margins, etc.) to back

into what equity value is worth

LBO

– Similar to a DCF analysis, but a LBO shows an investor how much it can pay in

order to achieve its target equity return

– Can simulate return scenarios under various capital structures

Public Comparables

– Evaluate what EBITDA multiples similar businesses trade at in today’s market

Precedent Transactions

– Review what similar private businesses were acquired for within the last 12-24

months

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PE Market Overview PE Transaction Recommended Reading

2

TRIANGULATE IN ON FAIR PRICE THAT MEETS UNDERWRITING RETURN TARGETS

Due Diligence

Accounting

– Vet accounting practices and controls

– “Quality of earnings” report normally done to validate that

operating results are conservative

Business

– Evaluate product/service offering to validate financial model

– Analyze competitive landscape

– Review key employees

Environmental / Legal

– Scrutinize potential environmental and legal liabilities that could

impact a transaction

12

PE Market Overview PE Transaction Recommended Reading

3

FIND AND UNDERSTAND EVERY RISK ASSOCIATED WITH THE ACQUISITION

Transaction Financing

Equity

– Fund: capital call draws down equity from LPs in pro-rata fashion at close

– Management: existing management usually “rolls” equity

– Co-investors: LPs that directly invest in the equity outside of the fund

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, no amortization (principal payments) until maturity

13

CAPITAL STRUCTURES & FINANCING FLEX DURING DILIGENCE AS RISK IS UNDERSTOOD

4

Books “Applied Mergers & Acquisitions” – Robert F. Bruner

“Investment Banking: Valuation, Leverage Buyouts, and Mergers & Acquisitions” – Joshua Rosenbaum and Joshua Pearl

“Competition Demystified” – Bruce C. Greenwald & Judd Kahn

“Understanding Michael Porter” – Joan Magretta

Websites www.prequin.com

www.pehub.com

www.pitchbook.com

www.thedeal.com

www.dealbook.com

www.altassets.com

www.bloggingbuyouts.com

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PE Market Overview PE Transaction Recommended Reading