PRIVATE EQUITY INVESTMENTS

What is Private Equity (PE)?

ØInvestments in Private Equity most often involve either an invetsment of capital into an operating company or the acquisition of an operating company.

ØPrivate Equity is an asset class consisting of equity securities in operating companies.

ØCapital for Private Equity is raised primarily from Institutional Investors/High networth Individuals.

ØThere is a wide array of types and styles of Private Equity and the term Private Equity has different connotations in different countries.

ØAmong the most common investment strategies in Private Equity include Leveraged Buyouts, Venture Capital, Growth Capital, Distressed Investments and Mezzanine Capital.

What is difference between Private Equity & Venture Capital?

Following are the major difference between Private Equity and Venture Capital:

Private Equity Venture Capital

§ Private equity funds prefer investments to ongoing businesses at later stages of growth via mezzanine or expansion financing. Private equity funds seek companies, which have reached a certain size (revenues exceeding $10m in Turkey), enjoy high operating profit, realise rapid growth, hold considerable market share, and create significant entry barriers in their sectors.

§ Seed, Start-up or Early Stage Companies with a business or product development plan are generally financed by venture capital funds

Considering the growth stage of companies and their financing reasons, the financial partnership investments can be made at different stages, like:Ø Seed FinancingØStart-up FinancingØEarly Stage FinancingØExpansion FinancingØMezzanine FinancingØLBOØMBO

These stages sometimes mark the distinction between Venture Capital and Private Equity Investments. Companies, that cannot realise profitable investment opportunities because of lack of funding and those are financially distressed but operationally viable, are attractive candidates for financial investments. The value created can be shared between the investors and investee.

Although the difference between Venture Capital and Private Equity Investments are not apparent in many cases, Seed, Start-up or Early Stage companies with a business or product development plan are generally financed by Venture Capital Funds whereas Private Equity funds prefer investments to ongoing business at later stages of growth.

Type of Private Equity

Following are the types of Equity:

Leveraged buyoutLeveraged buyout, LBO or Buyout refers to a strategy of making equity investments as part of a transaction in which a company, business unit or business assets is acquired from the current shareholders typically with the use of financial leverage. The companies involved in these transactions are typically mature and generate operating cash flows.

Venture capitalVenture capital is a broad subcategory of private equity that refers to equity investments made, typically in less mature companies, for the launch, early development, or expansion of a business. Venture investment is most often found in the application of new technology, new marketing concepts and new products that have yet to be proven.

Growth capitalGrowth capital refers to equity investments, most often minorityinvestments, in relatively mature companies that are looking for capital to expand or restructure operations, enter new markets or finance a major acquisition without a change of control of the business.

Distressed and Special SituationsDistressed or Special Situations is a broad category referring to investments in equity or debt securities of financially stressedcompanies. The "distressed" category encompasses two broad sub-strategies including:

– “Distressed-to-Control" or "Loan-to-Own" strategies where the investor acquires debt securities in the hopes of emerging from a corporate restructuring in control of the company's equity;

– "Special Situations" or "Turnaround" strategies where an investor will provide debt and equity investments, often "rescue financings" to companies undergoing operational or financial challenges.

In addition to these private equity strategies, hedge funds employ a variety of distressed investment strategies including the active trading of loans and bonds issued by distressed companies.

Mezzanine capitalMezzanine capital refers to subordinated debt or preferred equity securities that often represent the most junior portion of a company's capital structure that is senior to the company's common equity.

SecondariesSecondary investments refer to investments made in existing private equity assets including private equity fund interests or portfolios of direct investments in privately held companies through the purchase of these investments from existing institutional investors. Often these investments are structured similar to a fund of funds.

Other strategiesOther strategies that can be considered private equity or a close adjacent market include:

– Real Estate: in the context of private equity this will typically refer to the riskier end of the investment spectrum including "value added" and opportunity funds where the investments often more closely resemble leveraged buyouts than traditional real estate investments. Certain investors in private equity consider real estate to be a separate asset class.

– Infrastructure: investments in various public works (e.g., bridges, tunnels, toll roads, airports, public transportation and other public works) that are made typically as part of a privatization initiative on the part of a government entity.

– Energy and Power: investments in a wide variety of companies (rather than assets) engaged in the production and sale of energy, including fuel extraction, manufacturing, refining and distribution (Energy) or companies engaged in the production or transmission of electrical power (Power).

– Merchant banking: negotiated private equity investment by financial institutions in the unregistered securities of either privately or publicly held companies.

Why Private Equity?

Ø Institutional investors provide private equity capital in the hopes of achieving risk adjusted returns that exceed those possible in the public equity markets and will typically include private equity as part of a broad asset allocation that includes traditional assets (e.g., public equity and bonds).

Ø Most institutional investors do not invest directly in privately held companies, lacking the expertise and resources necessary to structure and monitor the investment.

Ø institutional investors will invest indirectly through a private equity fund.

Ø Certain institutional investors have the scale necessary to develop a diversified portfolio of private equity funds themselves, while others will invest through a fund of funds to allow a portfolio more diversified than one a single investor could construct.

Structure and Object of Private Equity

Private equity funds are pools of privately-managed capital, formed for the purposes of making investments in private companies. Privateequity funds are typically managed by the promoter of a fund (or an affiliated party) and this manager earns a fee for performing the investment management function typically consisting of (or including) a share of the profits generated by the fund.

Generally, investors in a private equity fund commit to invest a certain amount of capital when the fund is established and as the manager identifies suitable investments for the fund, these investors are required to advance the capital they have committed to invest.

A private equity fund invests its capital in companies identified by the managers, which are often referred to as “portfolio companies” or “portfolio investments”.

Typical StructurePrivate equity funds are typically structured as limited partnerships/trust. The general partner of a private equity fund will normally be the promoter of a fund or an entity related to it. The general partner is the party that, at law, is responsible for the management of the business of a limited partnership and assumes all of its liabilities. Often the general partner delegates management responsibilities to another entity, referred to as the manager, that is a related party of the fund promoter and general partner and that earns the management fee to manage the investments made by the fund. The investors in a private equity fund are the limited partners of the limited partnership.Generally, limited partners are not responsible for the obligations of the limited partnership and their liability is limited to the capital contributions that they have committed to make to the limited partnership. Limited partners cannot take part in the control of the business of the limited partnership and normally cannot withdraw from their obligation to meet their capital commitment.The life cycle of a private equity fund varies, but a fund is usually established for a term of 10 years, with the general partner having an option to extend the life of the fund for up to two years if necessary to allow for an orderly wind down.

Commitments and Draw DownsCapital contributions to pay management fees and operating expenses are usually advanced by (or “drawn down” from) limited partners periodically over the course of a fund’s life. Capital contributions to make portfolio investments are typically drawn down over an initial three to five year period known as the “commitment period”.Once the commitment period is concluded, the fund’s manager will monitor and manage investments to maximize value and realize returns over the life of the fund. Follow-on investments may require further draw downs of capital during this phase, but investments in new portfolio companies are usually prohibited. Average hold periods for private equity investments are less than five years, although the range of hold periods can be as much as 10 years.

Fees and DistributionsWhen portfolio investments are sold (or “realized”), a private equity fund will usually distribute investment proceeds to the fund’s limited partners. Generally, all capital realized is distributed to the limited partners until the value of the limited partners’ capital contributions has been returned to them, in addition to an amount representing a return on the limited partners’ investment (referred to as the “preferred return”).The limited partners’ preferred return is generally calculated as 6% to 8% of the funds invested capital per year. Once the limited partners receive their capital contributions and the preferred return, the next distributions made by the private equity fund (effectively representing the profits made by the fund) are typically allocated between the general partner and the limited partners.The general partner is usually entitled to 20% of the overall profits (an amount referred to as the “carried interest”). The order of priority in which a private equity fund makes distributions (as described above) is often referred to as the “distribution waterfall”.

The manager of the fund typically earns a management fee of 1.5% to 2.5% per year, throughout the life of the fund. Generally, the management fee paid during the commitment period, when the manager is sourcing new investments, is based on aggregate committed capital to the fund, and thereafter the fee is based on the amount of capital that is actually invested by the fund in portfolio investments.The management fee represents an expense of the fund, and is typically recouped by the limited partners before the manager is paid the carried interest. In a successful fund, the full cost to the limited partners of the services of the general partner and manager is therefore typically 20% of the total profit achieved by the fund.As a fund approaches its termination date, its remaining portfolio positions are liquidated or, in limited circumstances, are distributed to the limited partners.

Other Commercial TermsA private equity fund is typically governed by its limited partnership agreement, which is entered into between the general partner and the limited partner investors. Among the important terms and conditions generally found in a limited partnership agreement, in addition to those already referred to, are target investments and investment restrictions which set forth what the fund is expected and permitted to invest in, a successor fund provision which provides that the promoter and manager will not launch or manage another private equity fund until the first fund is substantially invested, the terms on which the limited partners may replace the general partner and the fund’s governance structure.

Minimum Size of Opportunity which may attract Private

Equity Investor?

Private-equity investing is not easily accessible for the average investor. Most private-equity firms typically look for investors who are willing to commit as much as $25 million. Although some firms have dropped their minimums to $5 million , this is still out of reach for most people.

Financial Parameters required to attract Private Equity Investor apart from

USP and Marketing Strategy

Accretion is focusing on later stage private equity transactionsrequiring an equity investment of up to $10m. This typically equates to an enterprise value of between $10m and $50m and provides an equity interest of between 20% and 80% in the investee.

Following are the parameters require to attract Private Equity Investor:Ø Turnover greater than or equal to Rs. 50 Crores (INR) / $10 million (USD)Ø EBIDTA greater than or equal to 18%Ø IRR greater than or equal to 22%Ø Shares Dilution greater than or equal to 20%Ø Business must have scalability

How Private Equity Investors Evaluate Investment

Opportunity

Considerations for investing in private equity funds relative to other forms of investment include:

– Substantial entry requirements. With most private equity funds requiring significant initial commitment (usually upwards of $1,000,000) which can be drawn at the manager's discretion over the first few years of the fund.

– Limited liquidity. Investments in limited partnership interests (which are the dominant legal form of private equity investments) are referred to as "illiquid" investments which should earn a premium over traditional securities, such as stocks and bonds. Once invested, it is very difficult to achieve liquidity before the manager realizes the investments in the portfolio as an investor's capital is locked-up in long-term investments which can last for as long as twelve years. Distributions are made only as investments are converted to cash; limited partners typically have no right to demand that sales be made.

– Investment Control. Nearly all investors in private equity are passive and rely on the manager to make investments and generate liquidity from those investments. Typically, governance rights for limited partners in private equity funds are minimal.

– Unfunded Commitments. An investor's commitment to a private equity fund is drawn over time. If a private equity firm can't find suitable investment opportunities, it will not draw on an investor's commitment and an investor may potentially invest less than expected or committed.

– Investment Risks. Given the risks associated with private equity investments, an investor can lose all of its investment. The risk of loss of capital is typically higher in venture capital funds, which invest in companies during the earliest phases of their development or in companies with high amounts of financial leverage. By their nature, investments in privately held companies tend to be riskier than investments in publicly traded companies.

– High returns. Consistent with the risks outlined above, private equity can provide high returns, with the best private equity managers significantly outperforming the public markets.

– For the above mentioned reasons, private equity fund investment is for those who can afford to have capital locked in for long periods of time and who are able to risk losing significant amounts of money. These disadvantages are offset by the potential benefits of annual returns which range up to 30% for successful funds.

What is the Investment process followed by Private

Equity Investor?

Following are the Investment Process followed by a Private Equity Investors:

Ø Investee Company may be approached by Private Equity Fund OR Private Equity Fund may be approached by Investee companyØ Start with Business PresentationØ Due Diligences

- Account Due Diligences- Legal Due Diligences- Secretarial Due Diligences

Ø Enterprise ValuationØ Term SheetØ Share Holder AgreementØInvestment

What is Normal Time Frame followed by Private Equity

Fund for Investment?

The normal time frame followed by Private Equity Fund for Investment is 3 to 4 months.

What is Role of Investment Banker and / or M&A

Advisor?

Investment Banker and M&A Advisor

Ø M&A Advisor provide service and advice to companies, organizations and governments.

Ø M&A Advisor also assist and advise companies on mergers and acquisitions, which basically means that they act as the buyer or seller (whatever position the company is taking) and negotiate the transaction.

Ø In other instances they just provide a strategy for action against an unwelcome bid.

Ø It is the duty of the M&A Advisor to provide advice on issues such as how to raise capital through equity or debt instruments.

Ø In addition to the above mention activities, investment bankers also governments deal with the privatization of public entities.

Ø A M&A advisor's main goal is to help clients achieve their goals.Ø M&A Advisor will assist their clients with the implementation of their

chosen plan, including but not limited to buyouts.

Ø M&A advisor also must take charge of their own client load. Ø M&A Advisor must identify and secure their own clientele, so they

literally have total control of how much or how little work they have. Ø M&A Advisor need the function using the most up-to-date news

sources, so they must receive real-time market updates. Ø In order to provide clients with the most accurate and effective

strategy, investment bankers need access to in-depth information and comprehensive research and financial modeling tools to analyze the market and formulate likely outcomes.

What is the Expectation of Return on Investment by Private Equity Investor?

Ø In the past the performance of private equity funds has been relatively difficult to track, as private equity firms are under no obligation to publicly reveal the returns that they have achieved from their investments.

Ø In the majority of cases the only groups with knowledge of fund performance were investors in the funds, academic institutes (asCEPRES Center of Private Equity Research) and the firms themselves, making comparisons between various different firms, and the establishment of market benchmarks to be a difficult challenge.

Ø The performance of the private equity industry over the past few years differs between funds of different types. Buyout and real estate funds have both performed strongly in the past few years (i.e., from 2003-2007) in comparison with other asset classes such as public equities. In contrast other fund investment types, venture capital most notably, have not shown similarly robust performance.

ØWithin each investment type, manager selection (i.e., identifying private equity firms capable of generating above average performance) is a key determinant of an individual investor's performance.

Ø Historically, performance of the top and bottom quartile managers has varied dramatically and institutional investors conduct extensive due diligence in order to assess prospective performance of a new private equity fund.

Ø It is challenging to compare private equity performance to public equity performance, in particular because private equity fund investments are drawn and returned over time as investments are made and subsequently realized.

Ø Return on Investment is not less then 25% IRR per Annum

How to do Valuation of Company?

Ø Business valuation is a process and a set of procedures used to estimate the economic value of an owner’s interest in a business.

Ø Valuation is used by financial market participants to determine the price they are willing to pay or receive to consummate a sale of a business.

Ø In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolvedisputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes.

Which are the Financial Instruments used by

Private Equity Investor for Investing Purpose?

Following are the Financial Instruments used by Private Equity Investors:

ConvertiblesIn finance, a convertible note (or, if it has a maturity of greater than 10 years, a convertible debenture) is a type of bond that the holder can convert into shares of common stock in the issuing or cash of equal value, at an agreed-upon price. It is a hybrid security with debt- and equity-like features. Although it typically has a low coupon rate, the instrument carries additional value through the option to convert the bond, and thereby participate in further growth in the company's equity value.

Optional Convertible DebenturesThey are a derivative of convertible debentures with an embeddedoption, providing flexibility to the issuer as well as the investor to exit from the terms of the issue. The coupon rate is specified at the time of issue.

Preference SharesCapital Stock which provides a specific dividend that is paid before any dividends are paid to common stock holders, and which takes precedence over common stock in the of a liquidation. Like common stock, preference shares represent partial in a company, although preferred stock shareholders do not enjoy any of the voting rights of common .

Also unlike common stock, preference shares pay a fixed dividend that does not fluctuate, although the company does not have to pay this dividend if it lacks the financial to do so. The main benefit to owning preference shares are that the investor has a greater claim on the company's assets than common stockholders. Preferred shareholders always their dividends first and, in the event the company goes bankrupt, preferred shareholders are paid off before common stockholders. In general, there are four different types of preferred stock: cumulative preferred, non-cumulative, participating, and convertible.

Equity SharesIn business and finance, a share of stock (also referred to as equity share) means a share of ownership in a corporation (company). Equity investment generally refers to the buying and holding of shares of stock on a stock market by individuals and funds in anticipation of income from dividends and capital gain as the value of the stock rises.

It also sometimes refers to the acquisition of equity (ownership) participation in a private (unlisted) company or a startup (a company being created or newly created). When the investment is in infant companies, it is referred to as venture capital investing.

What is Tag Along?

A tag-along right is a legal concept in corporate law. The right assures that if the majority shareholder sells his stake, minority holders have the right to join the deal and sell their stake at the same terms and conditions as would apply to the majority shareholder. This right protects minority shareholders. Tag-along rights are fairly standard terms in shareholders agreements.

What is Drag Along?

A right that enables a majority shareholder to force a minority shareholder to join in the sale of a company. The majority owner doing the dragging must give the minority shareholder the same price, terms, and conditions as any other seller.

How long Private Equity Investor will Stay with

Company?

A Private Equity Investor will stay with company for maximum 3 to 5 years. Following are the reasons, why a Private Equity Investor will come out:

Ø IPOØ Strategic Buyout / Other Private Equity BuyoutØ Buyback

What is Exit Strategy of Private Equity Investor?

A private equity fund's ultimate goal is to sell or “exit” its investments in portfolio companies for a return (known as internal rate of return or "IRR") in excess of the price paid. These exit scenarios historically have been an IPO of the portfolio company or a sale of the company to a strategic acquirer through a merger or acquisition (M&A), also known as a trade sale. Increasingly more common has been a sale of the portfolio company to another private equity firm, also known as a “secondary sale”. In prior years, another exit strategy has been a preferred dividend by the portfolio company to the private equity fund to repay the capital investment, sometimes financed with additional debt (though this is currently difficult to obtain).

Private equity firms generally receive a return on their investments through one of the following avenues:

– an Initial Public Offering (IPO) - shares of the company are offered to the public, typically providing a partial immediate realization to the financial sponsor as well as a public market into which it can later sell additional shares;

– a merger or acquisition - the company is sold for either cash or shares in another company;

– a Recapitalization - cash is distributed to the shareholders (in this case the financial sponsor) and its private equity funds either from cash flow generated by the company or through raising debt or other securities to fund the distribution.

Debts versus Private Equity?

Despite a continuous effort to make the credit system increasingly flexible, more and more enterprises in the economy are now going in for Private Equity funding. The shift from the traditional bank loans to private equity flow marks a new trend in the economy.India is the second largest Private Equity market in the Asia Pacific region after Australia. Projections for this year by Venture Intelligence, the leading provider of information and networking services to the private equity and venture capital ecosystem in India, initially speculated a sharp increase in the Private Equity dealings in the year 2008.They provide not just the capital, but also strategic advices on various issues such as corporate governance, M&A, etc. Additionally, the enterprise can also capitalize on the PE firm’s global network. The PE investments in firms have helped the firms expand their capital base. Meanwhile, the credibility of the investment firm helps the company to get an easier access to the bank loans. The valuation of the company improves, providing for better pricing in IPO’s.Also, the increasing interest rates have made this type of financing more attractive for a company. As the capital requirements increase, the actual proportion of debt and PE in total investment will depend totally on the type of sector vying for financing.

A case study of Private Equity fund – How to create

and Run Successfully?

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