Introduction to Private Equity and Venture Capital_aifsession6.pptx
- 1. Introduction to Private Equity and Venture Capital PGCSM 2022-2023
- 2. What is Private Equity? β’ Private equity is capital that is not noted on a public exchange. β’ Private equity is composed of funds and investors that directly invest in private companies, or that engage in buyouts of public companies, resulting in the delisting of public equity. β’ Institutional and retail investors provide the capital for private equity, and the capital can be utilized to fund new technology, make acquisitions, expand working capital, and to bolster and solidify a balance sheet.
- 4. Business Life Cycle β’ Launch: A company begins its operations by launching new products or services. During the launch phase, sales are low, but slowly increasing, initial startup costs are high, with losses in this phase and negative cash flows. β’ Growth: Companies experience rapid sales growth with profits beyond break-even point and positive cash flows. β’ Shake-out: Sales continue to increase, but at a slower rate, usually due to either approaching market saturation or the entry of competitors with profits starting to decrease. β’ Maturity: Sales slowly decrease. Profit margins get thinner with stagnant cash flows. Many businesses extend their business life cycle during this phase by reinventing themselves and investing in new technologies and emerging markets. β’ Decline: Sales, profit, and cash flow all decline.
- 5. Corporate Funding Life Cycle
- 6. PE β Four Different Forms of Investment β’ Venture capital β equity investments in less mature non-public companies to fund the launch, early development, or expansion of business. β’ Growth capital β minority equity investments in mature companies for expansion, restructuring of operations, financing an acquisition or entering a new market, without a change of control of the company.
- 7. PE β Four Different Forms of Investment β’ Mezzanine capital β investment in subordinated debt or preferred stock of a company without taking voting control of the company. β’ The gap in funding between senior debt and equity is common for the following reasons: 1) accounts receivable, inventories and fixed assets are being discounted at greater rates than in the past for fear that their values will not be realized in the future; 2) many balance sheets now contain significant intangible assets, 3) as a result of defaults and regulatory pressure, banks have placed ceilings on the amount of total debt a company can obtain.
- 8. PE β Four Different Forms of Investment β’ While additional liquidity can be obtained from equity investors, equity is the most expensive source of capital. Further, equity capital, by its nature, dilutes existing shareholders. β’ As a result, mezzanine debt can be an attractive alternative way to obtain much needed capital.
- 9. PE β Four Different Forms of Investment
- 10. PE β Four Different Forms of Investment β’ Leveraged buyout (LBO) β purchase of all or most of a company or a business unit by using equity from a small group of investors in combination with a significant amount of debt. LBO targets are mature companies generating strong operating cash flows. β’ Ex. In 2007, Blackstone Group bought Hilton Hotels for $26 billion through LBO. Blackstone put up $5.7 billion in cash (and $0.8 bn later)and financed $20.5 billion in debt from a group of 26 big banks, hedge funds, and real estate debt investors. Before the financial crisis of 2009, Hilton had issues with declining cash flows and revenues. Hilton later refinanced at lower interest rates and improved operations. β’ BS bought back some debt at deep discount and by issuing shares. Hilton again became public in Dec 2013 with second IPO of $2.3 bn. With 76 percent of the equity, Blackstoneβs stake in Hilton was worth at least $15 bn. That is a profit, on paper at least, of more than $8.5 billion.
- 11. Private Equity AUM - $2.8 tn
- 12. Private equity-AUM β’ Private equity continued to drive global growth in private markets. Fundraising rebounded across regions, and global totals fell just short of the pre-pandemic peak established in 2019. AUM reached an all-time high of $6.3 trillion, driven primarily by asset appreciation within portfolios. With a pooled IRR of 27 percent in 2021, private equity (PE) was once again the highest-performing private markets asset class
- 13. Some PE/VC Terminology General partner (GP): An entity that raises capital from limited partners for a fund and determines which assets the fund should invest in. Limited partner (LP): An entity that commits capital to a general partnerβs fund. Limited Partnership A legal entity composed of a general partner and various limited partners. The GP manages the investments and is liable for the actions of the partnership while the LPs are generally protected from legal actions and any losses beyond their original investment. The GP receives a management fee and a percentage of profits (Carried interest), while the LPs receive income and capital gains.
- 14. Some PE/VC Terminology Portfolio company: A company that has received an investment from a venture capital or private equity firm. Lead investor: The investor that makes the largest investment in a venture capital round. As the primary financier of the round, the lead investor determines the valuation of the company. Investment bank: A financial institution that serves as an agent or underwriter for security issuances. Some investment banks also act as brokers/dealers and provide advisory services for mergers, acquisitions, restructurings and other transactions.
- 15. Some PE/VC Terminology Accelerator: A program startups can apply to that provides funds and mentorship to help companies grow, usually in exchange for equity. Most accelerators focus on helping early-stage companies. Incubator: An organization that gives early-stage companies office space, resources, advice and networking opportunities (usually in exchange for equity). Stage The period in a VCβs life at which investment is made. Stage is one of the two main ways of classifying and distinguishing Venture transactions (the other being by sector) and is divided into seed, early, mid and late.
- 16. Some PE/VC Terminology Venture capital: A type of private equity investing that focuses on startups and early-stage companies with long-term, high-growth potential. Vintage year: When a fund closes and starts investing. Angel: A high-net-worth individual who makes direct investments into early-stage companies. Bootstrap To bootstrap a company means to develop it without the assistance of professional Venture Capital. Instead, the founders make do with their own assets, capital from angel investors and any cash flows which they can generate from the companyβs own business activities or assets.
- 17. Some PE/VC Terminology Unicorn A VC-backed company with a valuation of $1B or more. A round Successive rounds of funding for a Venture company are given successive letters, like A,B etc. New VC investors can be introduced in each round. An A round is usually defined as the first round but it may be preceded by one or more angel rounds or by a seed round. Anti Dilution Provisions commonly found in the funding agreements governing rounds of investment in Venture companies under which the shareholdings of certain shareholders (typically early-stage investors and entrepreneurs) cannot fall below a specified percentage of the whole.
- 18. Some PE/VC Terminology Fund The investment vehicle, often a limited partnership, to which the limited partners commit capital. Syndicate A group of investors that agree to participate in a round of funding for a company. Dry Powder Unused capital which is, as yet, still available for drawdown and investment. Go shop A contractually agreed period during which the owner of a business can solicit offers for its sale at a price in excess of that already agreed with a vendor, in default of which the sale to the vendor will proceed. Should the owner be successful in soliciting a higher offer, then a walkaway fee will usually be payable.
- 19. Fund of Funds β’ A private equity fund of funds consolidates investments from many individual and institutional investors to make investments in a number of different private equity funds. β’ This enables investors to access certain private equity fund managers that they otherwise may not be able to invest with, diversifies their private equity investment portfolio, and augments their due diligence process in an effort to invest in high-quality funds that have a high probability of achieving their investment objectives. β’ Private equity funds of funds represent about 15% of committed capital in the private equity market.
- 20. Secondary Markets for Private Equity β’ A secondary market has developed for private equity as banks and other financial institutions attempt to sell their PE investments to reduce the volatility of earnings and rebalance portfolios. β’ In addition, individuals and institutional investors are also sellers of LP interests in PE funds. β’ Secondary market sales fall into one of two categories: a) the seller transfers a LP interest in an existing partnership that continues its existence undisturbed by the transfer, b) the seller transfers a portfolio of PE investments in operating companies.
- 21. Secondary Markets for Private Equity β’ Sellers of PE investments sell both their investments in a fund and their remaining unfunded commitments to the fund. β’ Buyers of secondary interests include large pooled investment funds and institutional investors, including hedge funds. β’ In addition, the private equity fund that originally invested in a company will sometimes purchase secondary market offerings.
- 22. Private Investment in Public Equities (PIPE) β’ Many PE firms are making private investments in public equities (PIPEs). These are minority investments in 5 to 30% of the stock of a publicly traded company and the investments are made without using debt financing. β’ The return potential of these investments depends on the actions of the management of the company, who are not controlled by the PE fund. β’ Ex. - Blackstoneβs acquisition of a 4.5% equity stake in Deutsche Telekom for $3.3 billion, KKRβs purchase of a $700 million convertible bond from Sun Microsystems.
- 23. PE Club Transactions β’ When the size of a potential acquisition by a private equity firm exceeds around 10 to 15% of the capital in a fund, the possibility of a βclub transactionβ is considered. β’ In a club deal, two to five different private equity firms coordinate to co-invest in a target company. β’ The benefits include spreading economic risk, sharing expertise, pooling of relationships with financing sources, reduction of costs per firm, and reduction in competition. β’ The challenges include increasing exposure to a single large transaction for limited partners who have capital invested in more than one of Club Transactions.
- 24. Private Equity vs Hedge Funds β’ The investment strategies of PE firms differ to those of hedge funds. β’ Typically, PE investment is geared towards long-hold, multiple-year investment strategies in illiquid assets (whole companies, large-scale real estate projects, or other tangibles not easily converted to cash) where they have more control and influence over operations or asset management to influence their long-term returns. β’ Hedge funds usually focus on short or medium term liquid securities which are more quickly convertible to cash, and they do not have direct control over the business or asset in which they are investing.
- 25. Private Equity vs Hedge Funds β’ Both PE firms and hedge funds often specialize in specific types of investments and transactions. PE specialization is usually in specific industry sector asset management while hedge fund specialization is in industry sector risk capital management. β’ Finally, PE firms only take long positions, for short positions is not possible in this asset class.
- 26. Portfolio Company Capitalization β’ Debt (50β70% of overall cap structure) - Senior bank debt, two types: Revolving credit facility, which can be paid down and reborrowed as needed and Term debt (senior and subordinated) - Junior debt, two types: High-yield (typically public markets) and Mezzanine (subordinated notes, typically sold to banks, institutions, and hedge funds) β’ Equity (30β50% of overall cap structure) - Preferred stock - Common stock
- 27. Some Large PE Firms PE Firm Year of Establishment AUM (2017) in $ billion The Blackstone Group 1985 434 Kohlberg Kravis Roberts 1976 148 The Carlyle Group 1987 201 TPG Capital 1992 75 Warburg Pincus 1966 40 Advent International 1984 31 Apollo Global Management 1990 248 CVC Capital Partners 1981 70 Bain Capital 1984 75 Apax Partners 1969 51
- 28. History of Venture Capital β’ VC in US developed in the late 19th. and early 20th. Century. β’ When Alexander Graham Bell needed money in 1874 to complete his experiments on telephone, Boston Attorney, Hubbard and Salem leather merchant, Sanders helped out and later put up the capital to start Bell Telephone Co. in Boston. β’ The first modern VC was formed in 1946 when MIT President Karl Compton and others set up American Research and Development (ARD) to finance commercial applications of technologies. ARD is the βfather of venture capitalβ. β’ With its support developed High Voltage Engineering Company (X-Ray, 1947), Digital Equipment Company (computers, now with HP, 1957) and others.
- 29. History of LBO β’ The first LBO transaction was completed in 1955, using a publicly traded holding company as an investment vehicle to borrow money and then acquire a portfolio of investments in corporate assets. β’ This activity gained momentum during the 1960s when Warren Buffet (through Berkshire Hathaway) and Nelson Peltz (through Triarc) made leveraged investments. β’ During the 1970s a group of bankers at Bear Stearns, including Jerome Kohlberg and Henry Kravis, completed a number of leveraged investments, but in 1976 these bankers left Bear Stearns to organize their own firm, which was called Kohlberg Kravis & Roberts (KKR).