BYVIJAY MEHTA

Private Equity

Dissecting Private Equity

What is Private Equity?

Why Should Your Clients Do It?

Why Should Your Clients Not Do It?

Investment Routes

Have new investors missed the boat?

What is Private Equity?

Venture Capital

Leveraged Buy-out (LBO) Business

Venture Capital

Description

Application

R&D

Prototype

Sells equityto provethe idea

Start-up

Pre-operational

Product development and market testing

Early Stage

Expansion

Business is operational

Hire employees,buy equipment, fund working capital

Late Stage

Expansion

Initial sales encouraging

Workingcapital

Debt-ledfinance forfixed assets

Pre- flotation

Fundingallows plannedflotation

Working capital and second-generation product

Debt-ledfinance forfixed assets

Seed

Idea

Sells equityto investigatethe idea

Risk

Luminar - Venture Capital

Operator of theme bars

0

5000

10000

15000

20000

25000

91 92 93 94 95 96 97 98 99 2000

PBIT

€000

The LBO Business

Turnaround Replacement

capital Institutional

buy-out Management

buy-in Management

buy-out

Seller __________ Orphan Assets ___________

__ Business with no Owner Succession __

Management

Receiver

Desperate

Definitely Not

Family Shareholder

Regulatory Sale

Incumbent No No Yes but supplement

Risk

Dechra - An LBO From Gehe AG

The UK’s leading distributary vetenary drugs

0

2000

4000

6000

8000

10000

12000

14000

96 97 98 99 2000

PBIT

€000

Sources of Capital & Risk Profile

* Temporary phenomenon

LBOs Pre-flotation Expansion Capital

Start-UpSeed

Private Investors “Angels”

Specialist VCs

Public Markets*

Generalist VCs

Public Markets*

Generalist VCs

Investment Banks

Fund Managers

Buy-out Firms

Investment Banks

The Case For Private Equity

Private equity out performs over the long term

Source: WM Company/BVCA Performance Measurement Survey

It is a loosely-correlated asset

May be able to increase performance without materially increasing risk

1999 Private Equity Returns

per annum % 3 years 5 years 10 years

Private Equity* 31.1 27.2 20.0

FTSE All-Share 20.4 20.3 14.9

FTSE 100 22.2 21.8 15.6

FTSE SmallCap 15.5 15.6 10.8

Source: BVCA WM Company

* median return

1999 Private Equity Returns

per annum % 3 years 5 years 10 years

Total 31.1 27.2 20.0

Early Stage 15.8 16.6 8.7

Expansion Capital 30.3 26.9 12.6

Mid MBOs 19.9 22.1 17.3

Large MBOs 31.0 26.4 22.9

Source: BVCA WM Company

The Case Against Private Equity

High Risk

Low Liquidity

Risk

Single company risk:

Leveraged } Young } Moderate to high Smaller }

10 Year Record

Loss Ratio 7%

Returns 46.8% pa

Portfolio risk: Low

50

0

The cash flow for an investor in a private equity funds follows a J-curve

Years

Cas

hflo

w o

f in

vest

men

t £

1 2 3 4 5 6 7 8 9 10

Liquidity

Liquidity

Self-liquidating

Growing secondary market

Other Issues

MFR

Valuations

Private Equity

All UK pension funds should consider an allocation to private equity

5% to 10% of equities

How do you invest in private equity?

Direct

Private Equity Manager

Fund of Funds

Quoted Investment Trust

How do you select a manager

In the normal way:

People

Performance

Processes

Philosophy/Strategy

Have Investors Missed The Boat?

Europe Is Restructuring

0.00% 0.05% 0.10% 0.15% 0.20% 0.25% 0.30% 0.35%

UK

USA

NL

Scandinavia

France

Italy

Germany

Unquoted investment as % of GDP Source: EVCA

PII Group

E-Commerce

Dot.com

* Portfolio company of Mercury Private Equity

Profile

Example

Classic internetcompany -usuallyretail or portals.

Amazon.comQXL.comFreeserve

New Channel

‘Clicks and mortar’.

New secondary on-line

revenue streams.

Tesco, Dell, Clinphone*MapQuest.com*, 1-800 Batteries*, Trados*Global People Network*

Fulfilment

‘Bricks and mortar’.

Outsourced back

office (e.g. logistics)

of Dot.com

businesses.

Bertrams*Irish Express CargoBraitrim*Wincanton

Infrastructure

‘Bricks and mortar’.

Suppliers of equipment, software, services etc to Dot.com businesses.

IBMCISCOBT, Vitria*Agora*

Bertram Group

Private Equity

Long-term out-performance

Risk & liquidity concerns are overplayed

Use to increase returns without materially affecting risk

Expert funders of change at a time of restructuring

Definition of Terms

Investment Return

Detailed Schematic of MPE Investment Process

MPE Organisation Structure

Extract from MPE Business Planning Process

Appendices

Venture Capital:– Early Stage (“Seed to Start-up”): Capital for businesses in the conceptual stage or where products are not developed and revenues and/or profits may not have been achieved– Expansion Late Stage (“First stage to Mezzanine”): Growth or expansion capital for mature “businesses in need of product extension and/or market expansion. Sometimes

referred to as development” capital

Buy-out Capital: Equity capital for acquisition or refinancing of a larger company

Restructuring Capital: New equity capital for financially/operationally distressed companies

Mezzanine (/subordinated) debt:– Intermediate debt capital between equity and senior debt for acquisition or refinancing transactions– The debtholder participates in equity appreciation through conversation features such as rights, warrants or options

Carried Interest (“carry”): This represents the share of a private equity fund’s profit that will accrue to the general partners

Fund of funds: Private equity funds whose principal activity consists of investing in other private equity funds. Investors in fund of funds can thereby increase their level of diversification

General Partner (“GP”) /Sponsor: Managing partner of a Limited Partnership, who is responsible for the operations of the partnership and, ultimately any debts taken on by the partnership

Hurdle Rate (or Preferred Return): A hurdle return allows investors to get preferential access to the profits of the partnership. In absence of reaching the hurdle return, the general partners will not receive a share of the profits

Limited Partnership: Most private equity firms structure their funds as limited partnerships. Investors are the limited partners and private equity managers the general partners

Appendices - Definition of Terms

Appendices - Investment Return

6.5%

15.5%

20.0%

-2.0%-1.0%

13.5%

14.5%

-5.0%

-10%

-5%

0%

5%

10%

15%

20%

25%

0 1 2 3 4 5 6 7 8 9 10 11 12 13

YearYear

Illustrative data onlyIllustrative data only

IRRIRR

Portfolio construction

Harvesting

Value creation

Private equity investment return in a partnership typically follows a “J-curve” e.g. in the early years while investments are being made a Private Equity fund will show negative returns.

Growth buy-out £105m

Support Services Sector

Deal introduced by ‘primary contact’

Initial Appraisal: Market and technology leader,

under managed, requiring

first class CEO

Conversion: British Gas wanted

speedy and comprehensive

response - certainty

Diligence: 3 month exercise: key issues were

long term contracts, intellectual property and R & D

Negotiation &

Structure: Transneft contract

Exit: 1) Sale to leading oil-services group: Dresser, Schlumberger

Baker Oil & Tool

2) IPO

Business Plan Core business - improve utilisation

Acquisition - acquire Pipetronix/Rosen

New Products - fitness for purpose services

Organisation - make market facing,

change culture

Financials - double EBIT in 3 years

Appendices - Detailed schematic of MPE Investment Process: PII

Appendices - MPE Organisation Structure

R ich a rdM a th e w s

B enH e w e tson

Je re m yS h a rm an

S u p p o rt S e rv ic es

T h ie rryd e p an a fleu

N ic kM a rtin

M e d ia

Jo n a th onR e g is

T re vo rB a y le y

IanA rm ita ge

In fo rm a tio n &C o m m un ica tion

T e c h n o lo gy

T h o m asM ita rd

L in d sayD ib d e n

H e a lth c a re

S p e c ia lis tS e c to rT e a m s

R o m anP e lka

A n d re wH a y d en

T B A

N ic kT u rn e r

L B O

Jo a ch imP e ip e r

T re vo r B a y ley

F ra n k fu rt

G e n e ra lis tT e a m s

P h ilip p eS ch w a lb e r

T B A

P h ilip p e P o lle t

L isaS to ne

L o n d on

B u s in e ssA n a lyst

P o o l

F ra n ce s Ja cobH e a d o f Inve s tm e nt

Ia n A rm ita geM a n a g in g P a rtn e r

Appendices - MPE Business Planning ProcessProcess: The investment process is different to that employed by public security investors. The best is data driven, disciplined and designed to minimise judgement calls with the intent to add value. Here is the MPE process:

SELL!Deal

SourcingExit

PlanningOperationsInitial

AnalysisAppraisalDiligence Strategy

Negotiation Structuring Completion

Deals do not flow

Requires consistentmarketing

Normal disciplines

Get the first call

Key skill

Decision to allocate resource

Win confidence of counterparties

An important skill. Not all value items measured in £££’S agreement

Legal completion output is:

Shareholders

Employment contractsBanking documents

Sale & Purchase agreement

Warranties & Indemnities

Other contracts e.g. supply contracts

Management incentives

Complete through strategy review and business plan

Identify and effect improvements in operations

Detailed exercise for exit, c.2 years ahead of time

Either float, trade sale or recapitalisation

Combine internal resources

People

Accounting system & controls

Market positiondynamics

Technology

Facilities

Environmental

Insurance

Legal