what is pe & vc

8/18/2019 What is PE & VC

1/65


2/65

Module 1:

What is private equity

and venture capital?


3/65

Contents

About the author iv

Getting the most out of this module 5

The evolution of venture capital and private equity 5

Introduction 5

Evolution of the US market 5

Europe 6

Asia 7

The 1990s 8

The dot com bubble 8

Private equity today 8

Types of private equity 9

The private equity cycle – connecting institutionalinvestors and entrepreneurs 10

The limited partnership 11

Fund manager remuneration 12


4/65

About the author

Garry Sharp – independent practitioner, consultant, writer and trainer

Garry Sharp has 22 years’ experience as a practitioner, consultant, writer and trainer in the private

equity and venture capital markets. He joined independent venture capital company Baronsmead in

1985, becoming a director and shareholder following Baronsmead’s own management buyout in1989. During the early 1990s the company grew to become one of the UK’s largest independent pri-

vate equity firms and was acquired by fund manager Ivory & Sime in 1996. Shortly thereafter Garry

left to co-found Independent Direction, a specialist consultancy to the private equity industry. He sold

Independent Direction in 2005 to concentrate on training and writing, and continues to work in an

advisory capacity in private equity.

Garry has trained newcomers to private equity since 1990, and delivers courses in Western and

Eastern Europe, the Middle East and a wide range of African countries. His first book, The Insider’sGuide to Venture Capital, was published in 1990, followed by five more on private equity, M&A and

corporate finance.


5/65

The evolution of venture capital

and private equity Introduction

In 1957, American Research and Develop-

ment (ARD) – the world’s first ever investment

fund to specialise in backing start-up companies –

invested $70,000 for a 77 percent equity stake in a

new company created by four students with no

the basis that those who fail to learn from history

are condemned to repeat it – and there are partsof this story it would be better not to repeat – a

brief summary of the high and low lights will

bring perspective to all that follows.

Evolution of the US market

The early US venture capitalists were not invest-

ment managers in the conventional sense; rather

GETTING THE MOST OUT OF THIS MODULEWelcome to Module 1 in the Fundamentals of private equity series. This moduleintroduces the core principles of private equity and venture capital, examineshow they evolved and provides a broad introduction to today’s markets. It is

designed to work both as a stand alone section and as part of the whole series.For the benefit of the stand alone reader, a comprehensive glossary has beenincorporated, which explains the background and use of private equity terminol-

ogy. All terms which may require explanation or expansion are printed in bold,to indicate that there is a glossary entry for them.

Private equity – the provision of risk and reward sharing ( equity ) capital to a company whose shares are not freely traded on a recognised stock exchange ( private ).


6/65

after deciding to become part of a start-up, and was introduced through mutual friends. But it

soon became apparent that the company would need a heavyweight, experienced CEO with cred-

ibility on Wall Street.

The first attempts to recruit a CEO highlighted a serious issue – eBay had no VC backing. The fact

that with monthly profits of some $200,000 by early 1997 it did not need external funds was irrel-

evant; in Silicon Valley (eBay was based in San Jose, California) it was regarded as an essential

seal of approval for a company to have raised venture capital, to have been vetted and appraised

and to have passed the test. Without this, eBay couldn’t even get an executive search firm to work

for them.

The rule of thumb for a venture capital firm appraising an early stage investment was that there

had to be a clear route to making 10 times the original investment within three years. Benchmark

Partners, a venture capital manager itself only two years old, saw this potential in eBay and in July

1997 invested $6.7 million for a 25 percent equity stake on terms which valued the company at

$20 million before its investment (the pre-money valuation – see Module 4). eBay never spent

these funds – the money was left untouched in the bank – but capitalised on the contacts, credi-

bility and experience of Benchmark’s partners. It was Benchmark who recommended a search

firm to find a CEO, who instructed that firm to pursue a candidate who had declined their first

approach, and ultimately played a key role in persuading that candidate – Meg Whitman – that

she should leave her high profile, secure role at a major corporation, move her family to California

and join a tiny internet start-up.

In September 1998 eBay went public, achieving a listing at a market valuation of $2 billion; this

h d t $21 billi b th i f 1999 d i t f B h k it $6 7 il


7/65

Module 2:Private equity as an

asset class


8/65

Contents

About the author iv


Introduction 5

Terminology 5

Returns – and risk 5

Analysing risk in quoted markets 6

Risk in private equity 7

Assymetric risk and return 7

Using statistics in measuring private equity performance 7

Managing risk 8

Private equity performance 10

Measuring returns 10

Comparing private and quoted equity returns 11

R f ll i f d i i 14


9/65

About the author




1985, becoming a director and shareholder following Baronsmead’s own management buyout in

1989. During the early 1990s the company grew to become one of the UK’s largest independent pri-






Eastern Europe, the Middle East and a wide range of African countries. His first book, The Insider’s

Guide to Venture Capital, was published in 1990, followed by five more on private equity, M&A and

corporate finance.


10/65

GETTING THE MOST OUT OF THIS MODULEWelcome to Module 2 in the Fundamentals of private equity series. This modulefocuses on private equity as an asset class. It is designed to work both as a standalone section and as part of the whole series. It necessarily draws upon topics

reviewed in Module 1, and seeks to avoid repetition of their content. However, forthe benefit of the stand alone reader, a comprehensive glossary has been incor-porated, which explains the background and use of private equity terminology.

All terms which may require explanation or expansion are printed in bold, toindicate that there is a glossary entry for them.

Introduction

This module focuses on the private equity industry from the viewpoint of theinstitutional investors – pension funds, endowment funds, insurance companies

and banks – who provide its raw material – capital.

The emphasis here, unlike other modules in this series, is on performance issuesnot at the individual investment level but across funds, portfolios of funds and

the private equity industry as a whole. We are concerned with:

• How does private equity behave as an asset class – what are its characteristicsand how do they differ from quoted equities?

Wh d i tit ti l i t ll t it l t i t it ?


11/65

Exhibit 3: Distribution when one fund is chosen at random 100,000 times

Fund of funds multiple

Source: Capital Dynamics simulation of 1,755 US funds as at 31 December 2004.

P r o b a b i l i t y ( % )

0

5

10

15

20

25

30

5.04.54.03.53.02.52.01.51.00.50

Exhibit 4: Distribution when one, three, 10 and 30 funds are chosen at random 100,000 times

y ( % )

40

60

70

50

30 funds

10 funds

3 funds

One fund


12/65

mean that they are highly restricted in terms of the

information they can share with their investors.

The problem with governance in this environ-

ment is that it is required to protect a huge array

of interests – from shareholders, through

employees to much more broadly defined inter-

ests such as the environment and the broader

community – and to do so with a universally

applied set of rules and procedures.

By contrast a private equity backed management

team has a tightly defined shareholder group and

a governance structure tailored to a specific and

explicitly agreed set of objectives (explored fur-

ther in Module 8). The team can share detailed

information with its investors, discuss and obtain

specific consent for its strategies and plans, and

essentially operates in an unregulated environ-

ment where shareholders are assumed to be

sophisticated, able to look after their own inter-

ests and in need of no further protection than that

afforded by the tenets of corporate law.

Beyond the regulatory and governance issues,

h b d i l i h

Finally, of course, private equity not only offers

managers the prospect of significant financial

gain, but actively incorporates the generation of

wealth in its fundamental principles. This

approach centres on shared motivation between

shareholder and manager and represents a clear

solution to the perennial corporate management

challenge – the agency issue.

The agency issue

Managers act as agents for their shareholders,

and are required to make decisions in the best

interests of those shareholders. But in the quoted

company environment management may often

have vastly differing motivations from those

shareholders and, more importantly, different

means of achieving rewards.

Options to purchase shares, short-term perform-

ance related bonuses, golden parachutes, hand-

cuffs and hellos, large salaries, plus access to

corporate jets, properties, entertainment and

various other perks are all designed to attract

and motivate the highest performers to run

major companies. However no matter how care-

f ll h d i d d h i l


13/65

Module 3:

Structuring and raising

a fund


14/65

Published in September 2007 by:

PEI Media

Second Floor

Sycamore House

Sycamore Street

London EC1Y 0SG

United Kingdom

Telephone: +44 20 7566 5444

© 2007 PEI Media Ltd.

ISBN 1-904696-45-7 978-1-904696-45-2

This publication is not included in the CLA Licence so you must not copy any portion of it without the

permission of the publisher.

All rights reserved. No parts of this publication may be reproduced, stored in a retrieval system or

transmitted, in any form or by any means, electronic, mechanical, photocopy, recording or otherwise,

without the prior written permission of the publisher.

The views and opinions expressed in the book are solely those of the authors and need not reflect

those of their employing institutions.

Al h h bl ff h b d h f hi bli i h b


15/65

Contents

About the author iv


Terminology 5

Fundraising – making the case 5

The GP 6

Investment strategy and fund categories 6

Refining the proposal 7

Size and type of investment 7

Geography 7Sector focus 7

The management team 7

Investment track record 8

Dealflow generation strategy 8

Use of debt/financial structuring 8

Syndication 8

Due diligence processes 9


16/65

About the author













corporate finance.


17/65

GETTING THE MOST OUT OF THIS MODULEWelcome to Module 3 in the Fundamentals of private equity series. This modulefocuses on structuring and raising a fund. It is designed to work both as a standalone section and as part of the whole series. It necessarily draws upon topics

reviewed in earlier modules, and seeks to avoid repetition of their content.However, for the benefit of the stand alone reader, a comprehensive glossary hasbeen incorporated, which explains the background and use of private equity ter-

minology. All terms which may require explanation or expansion are printed inbold, to indicate that there is a glossary entry for them.

Terminology It is difficult to avoid confusion in the use of generic terms such as management,investor and investment when discussing private equity at the fundraising level.The private equity fund is the core part of the process. It raises money from

investors (who in turn are themselves managers of investment funds), and is man-aged by a private equity firm, often referred to as a general partner, but also as amanager or a management team. It then makes investments (hence becoming aninvestor) in private companies which in turn have their own management teams.

We therefore need to be careful in our choice of terms for the various partici-pants. By institutional investors, investors or limited partners, we mean the

i f d i i d h lik h ll i l i


18/65

not facilitate a tranched drawdown of commit-

ted capital. The Luxembourg SICAF is a simi-

lar vehicle to the SICAV but with fixed rather

than variable capital; SICAFs may issue partly

paid-in shares (provided a minimum of 25

percent of their par value is paid-up at the

date of issue) but a capital increase or

decrease requires a change of the articles of

incorporation by decision of an extraordinary

general meeting of shareholders.

The limited partnership is commonly viewed as

the vehicle of choice for private equity fund man-

agers and is the vehicle most often used for pri-

vate equity funds with an international investor

base. The other vehicles described above tend to

be used where a more limited range of investors

is targeted and/or where the manager's activity is

concentrated in particular jurisdictions, where a

non-partnership vehicle may be more appropri-

ate. The features of limited partnerships are con-

sidered in more detail below.

Limited partnerships

A limited partnership comprises a general partner,

h i ibl f h i d

• tax transparency;

• contractual flexibility;

• manager's autonomy (the limited liability of

each limited partner generally depends on it

not becoming involved in management);

• no/minimal regulatory requirements in

respect of the vehicle itself;

• potential for tax efficient management and

performance fee structuring; and

• no requirement for public disclosure of the

partnership agreement or the partnership's

accounts.

Meanwhile, the potential drawbacks of limited

partnerships may include the following:

• certain countries do not regard limited part-

nership vehicles as tax transparent, which

may necessitate establishing a separate paral-

lel vehicle for investors in such jurisdictions;

• it will not be possible for a limited partnership

to take advantage of the EU Parent/Subsidiary

directive (exempting dividends paid by sub-

sidiaries to their parents from tax), although

subsidiary companies owned by the limited

hi d i di id l i i h


19/65

Module 4:Venture and

development capital


20/65


PEI Media

Second Floor

Sycamore House

Sycamore Street

London EC1Y 0SG

United Kingdom

Telephone: +44 20 7566 5444


ISBN 1-904696-46-5 978-1-904696-46-9










21/65

Contents

About the author iv


Introduction 5

Identifying the opportunities – venture fund strategy 7

A dose of reality 9

Making investments 9

Generating dealflow 9

Early appraisal 9

Structuring investments 11

The principles of investment structuring 12

Assumptions and targets 12

Preference 13

Preferred shares in practice 13

Xytrak proposed terms 15


22/65

About the author













corporate finance.


23/65

IntroductionWe define early stage investing as the provision

of equity capital to companies that have not

yet achieved stable, profitable trading. Exhibit 1

quickly recaps (from Module 1) the definitions of

specific types of investment within this

broad category.

The factor which unites all investments of this

type is the significantly higher level of risk

attached to unproven companies, markets, prod-

ucts, technologies and management teams.

Uncertainty about future outcomes is endemic in

all forms of investment, but applies to nascent or

very young companies not only in every possible

GETTING THE MOST OUT OF THIS MODULEWelcome to Module 4 in the Fundamentals of private equity series. This modulefocuses on venture and early stage investing. It is designed to work both as a

stand alone section and as part of the whole series. It necessarily draws upon top-ics reviewed in earlier modules, and seeks to avoid repetition of their content.However, for the benefit of the stand alone reader, a comprehensive glossary hasbeen incorporated, which explains the background and use of private equity ter-


Exhibit 1: Classifications of investment types

Investmenttype

Purpose offunding

Investee companyCharacteristics

Keyobjectives

Typical exithorizon


24/65

exercise, without the danger of the company

agreeing a deal with a different investor.

In addition to the financial aspects we have

already discussed, the major commercial points

addressed in a term sheet are:

• preconditions to investment;

• representations and warranties;

• board structure and membership;

• provision of information;

• consent matters;

• share rights;

• service agreements;

• confidentiality;

• payment of costs;

• arrangement and monitoring fees; and

• exclusivity.

Preconditions to investment

Completion of the investment will always be

subject to the satisfactory completion of due

diligence, agreement of legal documents and

final approval from the investor’s investment

committee. In addition to these generic condi-

i h h ill l ll ifi

accurate, complete and not misleading. The prin-

cipal areas covered by warranties are:

• historic accounts;

• current trading and management accounts;

• financial projections and forecasts;

• the business plan;

• due diligence reports;

• ownership of assets including IP; and

• no litigation or contractual breaches

outstanding.

Board structure and membership

One of the major changes that accompanies rais-

ing venture capital for the first time is the intro-

duction of a formalised reporting and decision

making process, which will be centred around

the board of directors. The board acts as both the

primary decision making body and the maininterface between management and investor. It is

essential that board meetings are a forum for

open debate and discussion, and that the man-

agement team does not attempt this to circum-

vent this by making decisions in private and

presenting the board with fait accompli.


25/65

Module 5:Management and

leveraged buyouts


26/65


PEI Media

Second Floor

Sycamore House

Sycamore Street

London EC1Y 0SG

United Kingdom

Telephone: +44 20 7566 5444


ISBN 1-904696-47-3 978-1-904696-47-6



All rights reserved. No parts of this publication may be reproduced, stored in a retrieval system ortransmitted, in any form or by any means, electronic, mechanical, photocopy, recording or otherwise,






27/65

Contents

About the author iv


The buyout principle – three different routes to value creation 5Creating value in buyouts 5

The consequences of leverage 7

The future for value creation 7

Evolution of the buyout markets 8

Management buyouts 9

Failures 9

Investment criteria – characteristics of a buyout company 11Strategy and market positioning 11

The company 11

The management team 11

The buyout process 12

Auctions 12

Th t l i b t d fli t f i t t 12


28/65

About the author





1989. During the early 1990s the company grew to become one of the UK’s largest independent private equity firms and was acquired by fund manager Ivory & Sime in 1996. Shortly thereafter Garry






Guide to Venture Capital, was published in 1990, followed by five more on private equity, M&A andcorporate finance.


29/65

The explosive growth in buyouts over the last

three decades is a direct result of the natural,

inherent strengths of the buyout model. The

essential elements of this model are:

• a close partnership between the management

team of a buyout company and the investors

and lenders who finance its acquisition;

• precise and careful tailoring of the buyout’s

financial structure to the cash and profit gen-

eration characteristics of the company;

l bj i h d b

est and tax (EBIT) of €10 million. Adding back non

cash expenses – depreciation and amortisation – of

€4 million per year gives us an EBITDA , which is a

rough proxy for the company’s surplus operating

cashflow, of €14 million. This clearly provides thecapacity to service debt, and for this example we

assume that equity investors provide €30 million

of the acquisition cost, with the balance, €70 mil-

lion, coming as a combination of loans with an

overall interest cost of seven percent.

B i h i h i h f

GETTING THE MOST OUT OF THIS MODULEWelcome to Module 5 in the Fundamentals of private equity series. This modulefocuses on management and leveraged buyouts. It is designed to work both as astand alone section and as part of the whole series. It necessarily draws upon top-

ics reviewed in earlier modules, and seeks to avoid repetition of their content.However, for the benefit of the stand alone reader, a comprehensive glossary hasbeen incorporated, which explains the background and use of private equity ter-



30/65

Exhibit 4: Trends of buyouts/buy-ins, 1981–2006

Sources: CMBOR, Barclays Private Equity, Deloitte.

N u m b e r

V al u e ( € mi l l i on s )

0 0

2,000

4,000

6,000

8,000

10,000

12,000

100

200

300

400

500

700

800

600

2 0 0 6

2 0 0 4

1 9 9 7

1 9 8 9

1 9 8 1

2 0 0 2

2 0 0 1

1 9 9 3

1 9 8 5

2 0 0 5

1 9 9 9

1 9 9 1

1 9 8 3

2 0 0 3

1 9 9 5

1 9 8 7

1 9 9 8

1 9 9 0

1 9 8 2

1 9 9 4

1 9 8 6

2 0 0 0

1 9 9 2

1 9 8 4

1 9 9 6

1 9 8 8

Number

Value

Exhibit 5: Growing sponsor involvement in global M&A volume, 1999–2006

u m e

20

25

Volume ($ billions)

% of global M&A

519

356


31/65

Module 6:Private equity real estateand infrastructure


32/65


PEI MediaSecond Floor

Sycamore House

Sycamore Street

London EC1Y 0SG

United Kingdom

Telephone: +44 20 7566 5444


ISBN 1-904696-48-1 978-1-904696-48-3









33/65

Contents

About the author iv


Growth of the private equity real estate market 5

Real estate investment categories 6

Value added activities 7

Opportunistic 7

Real estate asset types 7

Infrastructure investments 8

Privatisations and buyouts 9Public private partnerships, concessions and new projects 10

Types of PPP 11

Private equity and infrastructure 14

Appendix 1: 20 landmark transactions in private equity real estate history 15

di h f hi


34/65

About the author













35/65

preceded the private equity hotel craze by a

good seven years.

In a transaction valued at more than $980 mil-

lion, the private equity groups acquired the

hotel portfolio from a 100-year-old publicly

held company that was controlled by a family

trust. Once the dust settled, Blackstone and

Colony had a clutch of luxury UK lodging

assets: The Savoy, Claridge’s, The Berkeley andThe Connaught. In addition to owning four of

the seven “superluxury” hotels in London, the

investor group walked away with The Lygon

Arms, a country-house hotel in the Cotswolds

region, and the quintessentially English restau-

rant Simpson’s-in-the-Strand.

In the buyer’s minds, the benefits of the trans-action were threefold. The firms held a major-

ity of London’s 1,250 luxury hotel rooms. In

addition, the hotels had recently seen a num-

ber of capital improvements that, according to

Blackstone, had affected annual numbers

without being seen in operating performance.

Fi ll h i b f

A gamble on Harvey’s

When Colony Capital spent $1.2 billion to buy

an additional four gambling parlours from

Harrah’s and Caesar’s last April, the firm

became the proud owner of the largest private-

ly held casino company. Although those invest-

ments have had a shaky first year, there is no

denying Colony’s strength in the gaming sector.

All of this was set in motion by one purchase:

the firm’s 1999 acquisition of Harvey’s Casino

Resorts in Lake Tahoe for $405 million. The

firm later sold the company, which also owns

hotels and casinos in Iowa, to Harrah’s for $625

million two years later.

“When Colony bought Harvey’s, we saw an

industry with only big, strategic players and no

one to sell to except each other,” Colony chief

executive officer Tom Barrack told sister publi-

cation Private Equity International last year.

“We thought we could act as a liaison to all

these larger companies Now the consolidation

1999 Colony’s first casino acquisition launchesan empire


36/65

Or, as Chuck Leitner, the global head of

RREEF, the real estate and infrastructure arm

of Deutsche Bank, puts it: “Just about every-

body that talks about infrastructure has

Australian accents.”

Contrasted with the mature infrastructure

ments with robust financing for public infra-

structure projects. In recent years, however, as

the country’s infrastructure has aged and the

ability to raise capital via taxes has dimin-

ished, more and more public entities are look-

ing to the private sector.

Exhibit A2.3: Private equity restructures – breakdown of global infrastructure deal volumes

by acquirer, 1998–2006 YTD

Source: Thomson Financial.

$ ( b i l l i o n s )

0

25

50

75

100

150

125

2006YTD

2000 2002 20041998 2001 2003 20051999

Private equity

Non-private equity

Year


37/65

Module 7:

Due diligence


38/65



Sycamore House

Sycamore Street

London EC1Y 0SG

United Kingdom

Telephone: +44 20 7566 5444


ISBN 1-904696-49-X 978-1-904696-49-0









39/65

Contents

About the author iv


What is due diligence? 5

Types of due diligence 5Commercial due diligence 5Financial due diligence 5Management due diligence 6Legal and regulatory due diligence 6IT due diligence 6Technology or product due diligence 6Environmental due diligence 6Forensic due diligence 6

Other specialist due diligence 7 Vendor due diligence 7

The due diligence process 7Professionalism 7Clear focus 7Careful planning 7

Allocation of resources 8


40/65

About the author













41/65

What is due diligence?In its simplest terms, we can define due diligence

as the process of assuring that all the assumptions

on which an investment or acquisition decisionare based do, in fact, hold true; an exercise in val-

idation or verification. In modern practice, how-

ever, it goes further than this, as the results of a

thorough, detailed and focused series of reviews

into a company’s markets, processes, finances,

management, technologies, assets, intellectual

d ill i id i

and sophistication, and in modern practice is

broken down into a series of different disciplines.

Commercial due diligenceCommercial due diligence (CDD), also referred to

as market, or strategic due diligence, is focused on:

• establishing the credibility of the revenue pro-

jections in the investee company’s business plan;

• providing an objective, impartial assessment

f h ’ k d i i i i

GETTING THE MOST OUT OF THIS MODULEWelcome to Module 7 in the Fundamentals of private equity series. This modulefocuses on the due diligence process. It is designed to work both as a stand alone

section and as part of the whole series. The module necessarily draws upon top-ics reviewed in earlier modules, and seeks to avoid repetition of their content.However, for the benefit of the stand alone reader, a comprehensive glossary has

been incorporated, which explains the background and use of private equity ter-minology. All terms which may require explanation or expansion are printed inbold, to indicate that there is a glossary entry for them.


42/65

Manufacturing due diligence expertise is supported by our dedicated manufacturing team whose

expertise has developed working on high profile strategy and operational engagements for majorinternational blue-chip manufacturers.

We also back our own market insights via the PA Ventures programme, as evidenced by the suc-

cessful spin-off of Ubinetics, the innovative 3G equipment supplier.

Recent examples of where PA has applied this specialised knowledge in strategic due diligence

assignments include:

A major European private equity deal where PA Consulting Group worked with an equity sponsor

on the due diligence of a specialist manufacturer of chemicals. By mapping the underlying man-

ufacturing technology to the changes in demands for various polymer and substitute products, PA

were able to greatly enhance the financial sponsors’ view of the key capital investment priorities.

For a 2006 deal, involving a major European PE house, PA Consulting Group were able to apply a

strategic due diligence team of manufacturing specialists to evaluate the real competitive advan-

tage of the core technologies, identifying potential market applications, and uncovering specific

high risk areas such as product warranty, all issues that materially impacted on the deal value.

A best practice approach to strategic due diligence

These cases illustrate how strategic due diligence, based on an ability to add value well beyond a

cursory market examination, has yielded significant deal value to our clients.

As the private equity mid-market becomes more competitive expect to see more financial sponsors


43/65

Module 8:

Aftercare and exits


44/65



Sycamore House

Sycamore Street

London EC1Y 0SG

United Kingdom

Telephone: +44 20 7566 5444


ISBN 1-904696-50-3 978-1-904696-50-6









45/65

Contents

About the author iv


Introduction 5

Aftercare 5

Protecting value 5Reporting structure 6Modern trends in reporting 6Informal reporting 6Board structure and composition 7Executive directors 7

Non-executive directors 7Representing the investor 7Monitoring progress and performance 7Contributing to growth and development 8Characteristics of the effective non-executive 8Board committees 8The chairman and board meetings 8Operating partners 9


46/65

About the author













47/65

IntroductionThe culmination of the investment process –

dealflow generation, appraisal, negotiation, duediligence, legal documentation and, finally,

completion of the investment – marks the begin-

ning, and not the end, of the investment cycle.

Whilst selection and structuring are critical to

private equity success, it is once the investment

has been made that the creation and realisation

f l b i Th i ’ ib i

AftercareThe aftercare function is driven by two key

objectives:

• protecting the value of the investment; and

• adding and realising value.

Exhibit 1 summarises the key aspects of the

investor’s role during the life of the investment.

GETTING THE MOST OUT OF THIS MODULEWelcome to Module 8 in the Fundamentals of private equity series. This module

focuses on the aftercare and exit aspects of the private equity cycle. It isdesigned to work both as a stand alone section and as part of the whole series.The module necessarily draws upon topics reviewed in earlier modules, and

seeks to avoid repetition of their content. However, for the benefit of the standalone reader, a comprehensive glossary has been incorporated, which explainsthe background and use of private equity terminology. All terms which may

require explanation or expansion are printed in bold, to indicate that there is aglossary entry for them.


48/65

Operating partners

Earlier modules – Module 5 in particular – iden-

tified the growing requirements for privateequity firms to add operational value to their

investee companies. This has led in many cases

to a significant change in the make up of many

firm’s executive teams, which have broadened

to include individuals with significant, senior

level operational experience and a deep under-

standing of a particular sector or market.

Although investors have always used externalconsultants and expertise to help them appraise

and develop companies, the incorporation of

operating partners into the team brings this

expertise into the equity ownership and carried

interest return pool, making them an integral

part of the team with a reward structure better

aligned to the creation of value. Specific mod-

els of operating partner involvement vary between firms.

At one extreme, major industry names are hired;

for example Louis Gerstner (former IBM chair-

man, currently chairman of Carlyle), Jack Welch

(former CEO of General Electric, at Clayton,

D bili d Ri ) d P l O’N ill (f US

potential for disruption and discord it can bring.

The risks it can entail include:

• friction caused by imposing a senior industry

figure on top of an existing management team;

• a lack of understanding of the private equity

approach by operating partners who come

from a major corporate background; and

• the added degree of risk entailed in backing a

company with an incomplete team, and rely-

ing on an operating partner’s input.

Aftercare – who does it

The question of where, and to whom, a private

equity firm should allocate responsibility for

aftercare is a source of perennial debate within

the industry. Broadly speaking, there are three

approaches:

• the original deal team retains responsibility

for the investment;

• responsibility is immediately passed to a dedi-

cated, specialist aftercare team; and

• there is a phased transition, with the original

deal team retaining the relationship for a peri-

d f i b f h


49/65

Module 9:

Secondaries andtheir alternatives


50/65



Sycamore House

Sycamore Street

London EC1Y 0SG

United Kingdom

Telephone: +44 20 7566 5444


ISBN 1-904696-51-1 978-1-904696-51-3









51/65

Contents

About the author iv


What drives the need for liquidity? 5

History – overview of the primary private equity market 6

The structural issue and transparency 7

The rise of specialised secondary funds 8

Secondary sales and purchases: practical issues 10

Difficulties in execution 10

Motivations of institutional investors: portfolio management 10

Recent variations: primary secondaries 11

More recent variations: direct secondaries 11

The fund managers’ perspective: investor relationships and stapled secondaries 12

The role of intermediaries 12


52/65

About the author

Kelly DePonte – Probitas Partners

Kelly DePonte is a partner and head of research and due diligence for Probitas Partners’ alternative

fund placement activities. Prior to joining Probitas Partners, Kelly was Managing Director at Pacific

Corporate Group, a leading provider of alternative investment advisory, managing and consulting

services to institutional clients, where he oversaw the partnership investment program. Before join-ing PCG, Kelly held various positions at First Interstate Bancorp in private equity, asset liability man-

agement and derivatives. He earned an MBA from the Anderson Graduate School of Management at

UCLA, and a BA in communications from Stanford University.


53/65

In any market, secondary activity is driven by

three major factors: volume in the primary mar-

ket, investment structure, and transparency.

Issues with all of these factors mitigated againstthe development of a strong secondary market

in private equity until the last decade, when the

growth of straight secondary sales and the cre-

ation of liquidity alternatives exploded. Even

though institutional private equity vehicles

have existed since the 1940s, the volume of

i i i h i k did

seller motivations. While some circles may still

stigmatise fund managers whose fund has been

sold, most transactions are driven by the strate-

gic needs of the seller. In fact, in dollar terms,most transactions have been driven by large

financial institutions – such as banks and insur-

ance companies – who have decided that pri-

vate equity is not a core business and who use

the secondary market to exit private equity

entirely, with the goal of redeploying capital

i b i li R l i i

GETTING THE MOST OUT OF THIS MODULEWelcome to Module 9 in the Fundamentals of private equity series. This modulefocuses on private equity secondaries and their alternatives. It is designed to

work both as a stand alone section and as part of the whole series. The modulenecessarily draws upon topics reviewed in earlier modules, and seeks to avoid

repetition of their content. However, for the benefit of the stand alone reader,a comprehensive glossary has been incorporated, which explains the back-ground and use of private equity terminology. All terms which may require

explanation or expansion are printed in bold, to indicate that there is a glos-sary entry for them.


54/65

difficult to track, as the exact sub-allocations to

secondaries within fund-of-funds, or allocations

within institutional investors’ alternative pro-grams are not widely advertised and can also be

flexibly adjusted. In total, however, the amount

of money focused on secondary market investing

is in the range of two to three times the amount

raised for specialised secondary funds.

Secondary sales and purchases:

practical issuesDifficulties in execution

Though secondary sales have been around for a

long time, there are a number of issues that make

the execution of secondary transactions difficult.

Problems with the traditional sales process

include the following:

• The potential for deep discounts. Secondary

purchases are usually executed at a discount

to the fund manager’s carrying value though

the level of discount fluctuates with market

forces. (A more detailed primer on secondary

pricing dynamics is included in Appendix 3 on

25 26 ) Th h h 1990 h

which mandate that, before a position can be

transferred to another investor, current LPs in

the fund have the right to match the price.This clause can add to the complexity of the

sales process and affect details of the bidding

process.

• Due diligence can be intensive and disruptive.

The due diligence process that a buyer neces-

sarily performs in order to develop a firm bid,

especially in situations where the buyer is not

intimately familiar with the partnershipsbeing sold, is usually intensive and can be dis-

ruptive for both parties. This can result in

damaged relationships with the fund manager

– an important consideration for a buyer

whose interest in purchasing a position may

be driven by a desire to gain access to future

funds to be raised by that same GP.

• May impact the relationship with a fund man-ager and access to future funds. Selling a part-

nership, especially if it is part of a targeted

portfolio rebalancing effort as opposed to a

wholesale portfolio sale, may communicate

the message to a fund manager that its efforts

and the relationship are not valued. Just as the

h f hi i k


55/65

Securitised vehicles

To date, most of the effort in producing struc-tured vehicles has been in the primary market as

structured fund-of-funds, but the technology

developed in this area is now being applied in the

secondary market. The primary goal of these

structures as applied to private equity portfolios

is to decrease the discount to NAV on secondary

i i d k h f li

ity facility. Private equity portfolios are different

from most ABS situations in that, even with a sea-soned portfolio, new funding is required as com-

mitments are drawn down. Though the early

return of capital on certain investments provides

a means of funding future draw-downs, it is pru-

dent to arrange a liquidity facility or line of cred-

it with a bank to ensure that future commitments

ill b i i l dl f h

Exhibit 7: Secondary private equity ABS structure

Bank or insurancecompany

Structuredbond buyers

Purchasers of residual risk

Undrawncommitments

Investments

outstanding

Note: The difference in size between the facilities is driven by the discount and the need to over collateralise thetop rated tranches.

Liquidity facility

Portfolio being securitisedFinancing structure

“AA” tranche

“A” tranche

“BBB” tranche

“BB” tranche

“B” tranche

Equity tranche


56/65

Module 10:

Running a privateequity firm


57/65



Sycamore House

Sycamore Street

London EC1Y 0SG

United Kingdom

Telephone: +44 20 7566 5444


ISBN 1-904696-52-X 978-1-904696-52-0










58/65

Contents

About the author iv


The institutionalisation of private equity and its meaning for a general partner 5

Building the right structure: roles and responsibilities 6

Human capital: attracting and retaining talent 7

Human capital 7

Attracting talent 8

Retaining talent 8

Carried interest: meaning, uses and calculation 9

Meaning 9

Uses 9

Calculation 10

Effect of GP’s retirement on carried interest 11

i i h di l


59/65

About the author

David Huckfield – Baring Private Equity International

David Huckfield has 20 years’ experience in the international private equity industry as a partner of

Baring Private Equity. In 2004 he played a leading role in coordinating and structuring the 8-way man-

agement buyout of the Group from ING Bank. Previously he was Group Chief Operations Officer,

based in London, responsible for operations and compliance worldwide. During his tenure funds

under management grew from $100 million to $2 billion as the Group expanded from a pan-European

partnership with four offices to an inter-continental institution with a network of 18 offices in 13

countries managing more than 20 funds. He held more than 60 directorships across the Group and is

now a non-executive director of Baring Private Equity International with a focus on corporate gover-

nance standards. In this capacity he continues to chair the General Partner Boards of most of the

Group’s $3.4 billion of private equity funds operating in Russia, Asia, India, Europe and Latin America.


60/65

The institutionalisation of private

equity and its meaning for a

general partnerPrivate equity has long since ceased to be the nas-

cent industry it was when the first venture capi-

tal pioneers made it a recognisable business

more than quarter of a century ago.

Institutionalisation has been defined as “to make

part of a structured and usually well-established

” d h h hi d l h i

tions, to impose more and more regulation on

the private equity industry. Many of these regu-

lators now require practising professionals to

pass specialist tests and exams leading to GPs to

incur the expense of more formal training pro-

grammes before being licensed to operate.

Training programmes have also had to be

extended to include anti-money laundering pro-

cedures which can look like maddening bureau-

cracy to a GP dealing with world-renowned

institutional investors.

GETTING THE MOST OUT OF THIS MODULEWelcome to Module 10 in the Fundamentals of private equity series. This module

focuses on running a private equity firm. It is designed to work both as a stand

alone section and as part of the whole series. The module necessarily draws upon

topics reviewed in earlier modules, and seeks to avoid repetition of their content.

However, for the benefit of the stand alone reader, a comprehensive glossary has

been incorporated, which explains the background and use of private equity ter-

minology. All terms which may require explanation or expansion are printed in

bold, to indicate that there is a glossary entry for them.


61/65

of members including representatives of certain

larger (for example: exceeding $X million or Y

percent), Investors in the fund and sometimes

individuals with no affiliation to the fund. The

advisory council will meet at least twice a year to

receive a report from the GP on matters falling

within the jurisdiction of the advisory council

which may include:

• consenting to, reviewing or waiving any mat-

ter requiring their consent under the partner-

ship agreement such as departures from the

main investment strategy, investments that

exceed specified limits;

• approving the budget for partnership expenses;

• approving changes in named key men who

have left the employment of the GP;

• reviewing and/or approving portfolio valua-

tions; and

• reviewing and/or resolving conflicts of interest.

Delivery methods

The annual financial statements and associated

reports due under the partnership agreement

will normally by distributed by post but may also

b b il h d I ddi i GP

the private equity industry. Alternatively they may

be content to develop “home-made solutions”

using standard off-the-shelf spreadsheet, database

and presentation software.

The main factors that influence their preferred

choice of solution are the scale of their business,

the financial cost of replacing legacy systems and

the human resources required to achieve the

transition. Least inclined to embark on signifi-

cant investment in custom applications are the

small firms operating entirely from a single site

without any outsourcing of fund administration.

They are likely to have developed their own in-

house systems using proprietary software tools.

Larger firms with a more complex business

model, for example, operating internationally

and using third-party administrators are most

likely to be attracted by the prospects of

installing an “all singing-all dancing” custom-

built solution.

The main tasks that private-equity specific soft-

ware has to do relate to the source and applica-

tion of funds under management and include

h f ll i


62/65

Glossary


63/65


PEI Media

Second Floor

Sycamore House

Sycamore Street

London EC1Y 0SG

United Kingdom

Telephone: +44 20 7566 5444


ISBN 1-904696-53-8 978-1-904696-53-7










64/65

LP See Limited partner.

Management buy-in (MBI) Where an outside manager or team purchases an ownership stake

in a company and replaces the existing management team.

Management buyout (MBO) The acquisition of a company by its management team, usually in

partnership with external lenders and/or private equity investors.

Management fee The fee paid by a private equity fund to the fund’s manager, gener-

ally in the range of 1.5 percent to 2.5 percent of the fund’s commit-

ted capital per annum. The fee is intended to cover the manager’s

overhead and salary costs in finding, making and monitoring

investments. It will scale down in later years as the fund’s portfolio,

and hence the associated workload, reduces.

Management ratchet See Ratchet.

Mandatory redemption The requirement for a company to purchase all of an investor’s

shares, at a set price on a certain date.

Market flex Changes made to the terms of a loan (principally the interest rate),

within limits pre-agreed with the borrower, in order to match them

to market conditions when selling parts of the loan onto other

lenders in a syndicate

M k bili di A di li d h l i f d

The Fundamentals of Private Equity and Venture Capital

As the private equity and venture capital industry continues to

expand and evolve globally it is crucial that professionals

Fundamentals is a must-have companion for any private

equity firm investment group investment bank or advisory firm


65/65

expand and evolve globally it is crucial that professionals

entering the industry understand its many facets fully.The

Fundamentals of Private Equity and Venture Capital provides

a comprehensive manual to all those wanting an accessible,

informed and insightful guide to this dynamic asset class. This

unique series pulls together the ten most important topics on

private equity and venture capital and, as a set, delivers an all-encompassing guide to the subject. Whether a new entrant to

this market wanting to gain a clear understanding of the industry

or a professional needing to expand their knowledge on a

specific area, The Fundamentals of Private Equity and

Venture Capital is a vital resource to all those working in the

private equity or venture capital industry wherever you are

based in the world.

Brought to you by the team that publishes Private Equity Inter-

national and PrivateEquityOnline.com, The Fundamentals of

Private Equity and Venture Capital is split into ten modules anda detailed up-to-date glossary – essential for any professional in

need of an understanding of individual elements of the industry

or of the asset class as a whole.

These modules are:

What is Private Equity and Venture Capital?

Private Equity as an Asset Class

Structuring and Raising a Fund

Venture and Development Capital

Management and Leveraged Buyouts

Private Equity Real Estate and Infrastructure

Due diligence for Private Equity and Venture Capital Firms

Aftercare and ExitsSecondaries and their Alternatives

Running a Private Equity Firm

Glossary

1.

2.

3.

4.

5.

6.

7.

8.9.

10.

11.

equity firm, investment group, investment bank or advisory firm

engaged with the industry. It has been expressly written and

designed to deliver concise guidance and analysis, drawing

on the real-world expertise of its authors and editor.

KEY FEATURES

Fundamentals has been written and edited by threeestablished authors and professionals in the field of private

equity and venture capital: Garry Sharp, Kelly DePonte and

David Huckfield.

Modules include real world examples and case studies from

leading firms involved with private equity and venture capital.

Key articles from Private Equity International supply

relevant commentary and context.

The layout of every module has been designed to optimise

ease of use and comprehension, including valuable data in

charts and tables, boxed checklists and valuable sect ion

summaries.The language is accessible and friendly and delivers

important knowledge in a digestible way.

A list of recommended reading is included to enhance your

knowledge further.

A comprehensive and up-to-date glossary of industry terms

is included.

•

•

•

•

•

•

•

what is pe & vc

Documents