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James OGara

Ryan Brewer

October 2011

PE 101: Introduction to Private Equity

Private Equity and Venture Capital Club

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Todays Agenda

1. Overview of the Private Equity Industry / Asset Class

2. Basics of PE Investments

3. Current PE Industry Update

4. Useful Resources

5. Selected Case Studies

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1. Overview of the PE Industry

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Basics of Private Equity: Definitions

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Private Equity as an Investment Asset Class

Alternative asset classes

Low High

20%

High

Low

MediumRisk

Expected return

Private equity

Private equity

Hedge funds

Hedge funds

Commodities

Commodities

Equity

Equity

High-yield

bonds

High-yield

bonds

Corporate

bonds

Corporate

bonds

Government

bonds

Government

bonds

Deposits

Deposits

Low High

20%

High

Low

MediumRisk

Expected return

Private equity

Private equity

Hedge funds

Hedge funds

Commodities

Commodities

Equity

Equity

High-yield

bonds

High-yield

bonds

Corporate

bonds

Corporate

bonds

Government

bonds

Government

bonds

Deposits

Deposits

Alternative investments with a high-risk, high-return profile

Typically investing in illiquid, non-publicly traded or unregulated securities

High use of debt (financial leverage) to boost equity returns

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Range of Private Equity Investments

Descrip-

tion

VC

Second

stage

Third

stage

First

stageSeed

Expansion stageEarly stage

Bridge

loans

Working

capital for

expansion

Financing

of major

growth

Financing

during the

transition

from being

privately

to publicly

owned

Re-

search

and

proof of

concept

Product

develop-

ment and

initial

marketing

Initial

expansion

of sales or

manufac-

turing

Invest-

ments

in other

funds

Fund-

of-

funds

LBO

Private equity

Focus of PE101

Existingbusinessthat ex-periencedtradingdifficulties,with aview to re-establish-ing pros-perity

Turn-

arounds

Equity tofund growthin an estab-lishedbusinessvia internalexpansionor acquisi-tion

Buy &

build

Buy-

outs

Fundsprovided toenable amanage-ment teamto acquirea productline orbusiness

Start-up

Growth capital

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Industry History and Development

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PE Advantages and Disadvantages

Advantages Disadvantages

Historically attractive returns Levered returns on equity via high debt-to-

equity ratios

Long-term strategy, ability to add value

Diversification

Limited correlation to public markets (in theory)

Superior governance model

Helps to solve the principal-agent problem atthe board level

No public company costs or need to performwell on a consistent quarterly basis

Strong management incentives

Typically employ generous stock incentiveprograms, require co-invest from managers

Tax benefits

Tax shield through debt

Capital gains treatment for profits

Illiquid Typical 3-7 year holding period

Usually majority ownership

Difficult to mark-to-market

High fees

2% annual management fee and 20% of profits(2 and 20) is typical, coming down somewhat

Relies on leverage to enhance returns

Needs healthy bond and loan markets

High risklarge range between returns of topand bottom quartile fund

Increasingly competitive, particularly in somesectors/markets

More deals are intermediated vs.

proprietary, more auction processes

Large capital inflows into emerging markets

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2. Basics of PE Investments

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Typical Private Equity Fund Structure

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Private Equity Fund Life Cycle

Marketingand

fundraising

-1

Marketingand capital

raising

Transaction sourcing

Acquisition 1

Acquisition 2

Acquisition 3

Acquisition 4

0 1 2 3 4 5 6 7 8 9 10Year

Marketingand capital

raising

Acquisition 5

Limited partnerships with a fixed life of 7-10 years

Defined investment period

Fund may target 7-20 investments over its life

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Typical Deal Cycle

From screening to close of transaction can often take 6 months or more

Hold periods anywhere between 3 and 7 years are typical, depending on the type of investment

PE firm partner Investment banks

PE firm team PartnerAssociate

Investment banks Consultants Accountants Lawyers

PE firm partner Investment banks Lawyers

PE firm partner Consultants

PE firm partner Investment banks Lawyers Consultants

KeyPersonnel

Life cycleScreening

of deal

opportunities

Due diligence Entry Active ownership Exit

Deal Flow ScreeningStable CFsStrong

ManagementValue Creation Dynamics

Market Company Operations

(Growth andSynergies)

Management Financials Legal

Acquisition price Management

Incentives Financing Structure Maximise Returns Align Interests

Management

principles andstructure

Re-organisation Establish and

monitoraggressivebusiness plan

Strategic buyer IPO Other PE Secondaries

Activities

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Deal Sources

Non-core

asset from

corporate

Management

buy-out in need

of financing

Undervalued

public

company

(go-private)

Sale ofcompany by

another PE

firm

Family-owned

business with

no succession

plan

Distressed/

failing

company

The ability to source transactions is a key success factor for PE firms

Successful sourcing draws on deep industry relationships, a firms reputation, and appropriate timing

A typical firm will evaluate (on some level) hundreds of potential opportunities per year

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Due Diligence on Target Company

Overview of theTargetCos strategy and business model

Assess the feasibility of managements business plan

Identify operational, market, financial, environmental and other risk factors anddevelop a mitigation plan

Explore operational and market upside opportunities

Analyse the cash generation and debt capacity of TargetCo

Quantify the upside and downside

Macroeconomics outlook, sector thesis and trends

Check regulation of the given industry

Understand customer trends and behavior of the industry Analyse competitors within the same market segment

Firm level

Industry and

macro level

Valuation Considerations and Due Diligence Checklist

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Deal Structure Overview

Financing Structure Investment (Legal) StructureSimplified

Fund LLP

Acquisition Co.

General

Partner

Limited

Partners

BidCo

Bank

Mezzanine

Senior debt

Equity /

ShareholderLoans

Seller

Purchase

Price

Target

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Economics of the LBO Model

At Initial Investment At Exit

EBITDA 100 EBITDA 150

Purchase Multiple 8.0x Exit Multiple 8.0x

Purchase Price 800 Enterprise Value 1,200

Less: Debt (5x multiple) 500 Less: Debt Remaining 250

Initial Equity Investment 300 Exit Equity Value 950

300

950500

250

Debt

Equity

EBITDA growth of 50

FCF repays 250 of debt

InitialInvestment

Exit

Sources of 650 growth in equity

250 in debt repayment

400 in EBITDA growth (50 x8x multiple)

Potential for further growththrough multiple expansion

800

1,200

Investing in high cash-flow generating companies allows high leverage (debt)

Pay-down of debt over investment life boosts equity value relative to earnings/enterprise value growth

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Exit Considerations

Sale

IPO

Recapitalisation

Could be to a strategic party or another PE firm

Sale to strategic is company-dependent (needs to be a strategic fit)

Sale to PE firm is dependent on financing markets

Typically only a partial monetization at IPO, followed by subsequent secondary

offerings to sell down full stake

Enables participation in future growth

Not an exit, but rather a monetization event

Company re-levers and uses proceeds to pay large dividend

Often utilized if PE firm wants to partially monetize investment and either i) wants to

retain upside in business, or ii) cannot receive value it believes is appropriate

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3. Current PE Industry Update

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Private Equity Fundraising

661.9 676.5

297.1260.0

127.6

0

100

200

300

400

500

600

700

800

2007 2008 2009 2010 1H2011

PE funds raised peaked in 2007-2008

Fundraising has been slow to recover after the financial crisis, large overhang of dry powder remains

Private Equity Funds Raised (US$ billions)1

Note:1 Includes all PE funds (buyout, VC, mezzanine, secondary, etc.). Source: Preqin

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Private Equity Deal Activity

Deal volumes show a similar trend

Aggregate values have recovered somewhat since hitting a 5-year low in mid-2009

Private Equity Deal Activity (US$ billions)1

Note:1 Includes all PE funds (buyout, VC, mezzanine, secondary, etc.). Source: Preqin

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Private Equity Exits

Exit volumes have recovered strongly from the financial crisis as the large volume of deals originatedin 2005-2007 reach maturity

Private Equity Exit Activity (US$ billions)1

Note:1 Includes all PE funds (buyout, VC, mezzanine, secondary, etc.). Source: Preqin

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Private Equity Loan Market

The leveraged loan markets in the US and Europe began to rebound in 2010, with strong pricing gainsand more access to leverage for private equity transactions

This trend has continued in the first half of 2011, however the recent European debt crisis andcontinued market volatility in the US has brought volumes virtually to a halt in 2H 2011 so far

Pricing is decreasing and yields increasing in both the leveraged loan and high-yield bond markets

European Market ( billions)

Source: S&P LCD

US Market (US$ billions)

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Recent Trends and Challenges

Growth in

Emerging Markets

Funds increasingly turning to higher growth emerging markets as US/EU stagnates

Risk of over-heating in several markets: China, Brazil, India

Increased

Specialization

Demand from LPs and more competitive marketplace leading firms to increasinglyspecialize in a particular geography or sector

Larger firms expanding sector teams or raising separate, specialized funds (Carlyle model)

Recent Fund

Performance

Returns performance of many funds raised in 2005-2007 has been poor

Fundraising difficulties for funds that have underperformed, firms raising smaller funds

Regulation Industry is increasingly being targeted by regulators/politicians, particularly in Europe

Accusations of asset-stripping, outsized compensation, poor employment record

Trends

Challenges

Emphasis onValue Creation

Reduced availability of leverage means firms are more reliant on value creation for return Creation or investment in separate portfolio company teams

Expanding

Secondary Market

Secondary market for LP interests developed in mid-2000s and has continued to expand

Many large secondary funds raised in the last 2 years

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4. Useful Resources

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Private Equity Resources

Industry Associations

BVCA: www.bvca.co.uk

EVCA: www.evca.eu

Emerging Markets Private Equity Association: www.empea.net

News

Subscribe to NYTimes DealBook for daily emails aggregating major PE storieshttp://dealbook.nytimes.com/

eFinancial News: Comprehensive industry news sourcewww.efinancialnews.com FT Private Equity coveragewww.FT.com/privateequity

PE Hub: Daily email with industry news and commentary, venture-focusedwww.pehub.com

S&P LCD: Like their facebook page for free access to leverage finance market stats www.facebook.com/lcdcomps

Library Databases

Capital IQ: Very useful for deal info and downloading excel financials / valuation stats for public companies

Bloomberg: Transaction searches and public company data (also get their iPhone app, its amazing)

VentureXpert

Venture Capital Report Directory

http://dealbook.nytimes.com/http://www.efinancialnews.com/http://www.ft.com/privateequityhttp://www.pehub.com/http://www.facebook.com/lcdcompshttp://www.facebook.com/lcdcompshttp://www.pehub.com/http://www.ft.com/privateequityhttp://www.efinancialnews.com/http://dealbook.nytimes.com/

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Academic and Research Resources

The Coller Institute at London Business School

Website aggregates research and case studies on private equity from the academic community

Semi-annual publication, Private Equity Findings, very useful for summary of latest PE research

Blog on their website: http://www.collerinstitute.com/

Textbooks and Reference Material

LBS Professors Eli Talmorand Florin Vasvari

Guy Fraser Sampson Josh Lerner

Felda Hardymon

Ann Leamon

Orit Gadiesh

Hugh MacArthur

Peter Temple

http://www.collerinstitute.com/http://www.collerinstitute.com/http://www.collerinstitute.com/