4. Private Equity

• Launch: VC (some GE)

• Growth: GE (some VC/BO)

• Maturity: BO (some GE)

• Decline: BO

• VC -> help launch business

• GE -> implement growth plans

• BO -> Develop new business plan

VC:

• Company type / size: New, $10M+

• Revenue: >$10M

• Control: Minority team approach

• Use of capital: MVP

• Time horizon: 5-10yrs

• Potential upside: 5-20x

• Target IRR: 30%-60%

• Risk: Very high

GE:

• Company type / size: Established, $100M+

• Revenue: $25M+

• Control: Minority

• Use of capital: Revenue expansion

• Time horizon: 3-7yrs

• Potential upside: 3-8x

• Target IRR: 25%-40%

• Risk: Moderate-high

BO:

• Company type / size: Establushed, $100M+

• Revenue: $25M+

• Control: Full

• Use of capital: Earnings growth

• Time horizon: 3-5yrs

• Potential upside: 2-5x

• Target IRR: 20-35%

• Risk: Moderate

• PE Firm: Overall organization

• GP: carried interest

• Investment advisor: management fee

• PE fund: investment vehicle

  -> GP & advisor same staff but separate legal entities

• Provide capital where banks will not lend

• Exploit inefficiencies in private markets

• Offer limited liability to investors

• Align investor and company management interests

• Pool investor capital

• Investment DD

• Finance and develop private companies

• Control, mentor & monitor portfolio firms

• Source and execute exit opportunities

• Direct Investment

• PE Fund

• PE Fund with Co-Investment

• Fund-of-Funds

• LP invest in private companies directly

• Highest control -> lowest diversification

• LP invests in PE limited partnership

• GP manages investment on behalf of LPs

• Combination of fund investing and direct deals

• LP invests alongside the GP in specific deals

• LP invests in a fund that invests in other PE funds

• Highest diversification -> additional layer of fees

• Early negative retuns due to fees / investment costs / write-offs

• LAter positive returns as values is realized -> exits

• Seen in NAV, cash flows & IRR

• Early negative retuns due to fees / investment costs / write-offs

• Later positive returns as values is realized -> exits

  
  

• IRR

• NAV

• Cash Flows

• Fundraising Stages

• Investment Stages

• Value Creation Stages

• Harvesting Stages

• End of Fund Life

• Capital raised from investors

• Years: 0-1 (6-12 months)

• Capital deployed into portfolio companies

• Cash flows & NAV negative

• Years: 2-5

• Operational impovements

• Growth Initiatives

• Years: 3-7

• Exit investments & return capital to LPs

• Positive cash flow

• Years: 5-7

• Possible extension period (1-2 years)

• Windup and liquidation of remaining assets

• Management fees

• Accounting prudence

• Lemons mature faster than pearls

• Short-term bank loan (2-3 years)

• GP loan to finance investments before capital calling

• Secured by LPs capital commitments -> senior, secured, revolving facility

• Flexible deal timing

• Better CF management

• Lower administrative burden

• Higher IRR

• Beneficial for both parties

• Improves efficiency, trust & long-term outcomes

• Stable, reputable, and reliable LP capital

• Easier long-term planning

• Funding certainty

• Lower search costs for strong GPs

• Access to co-investments

• Priority access for future funds of GPs

• Risk that LP cannot meet capital call

• Can force asset sales or defaults

• Non-cash distributions to LPs

• Securities of a portfolio company

• Year of PE fund first capital call

• Used to compare fund performance across cycles

• Allows proceeds from exits to be reinvested

• Delays distributions to LPs

• VC-backed companies valued at $1bn+

• Reach high vlauation quickly

• Few home-runs capture most retuns

• Common in VC Investing

• Values an investment by estimating exit value

• Discounts exit value using a high required return

• Multiple PE firms bid for target company

• Multiple PE firms jointly acquire target company

• Financial firms buy non-financial companies to resell and earn returns

• Entry and Establish

• Build and Harvest

• Decline, Exit or Transition

• Characteristics: Differentiation of fund -> difficult fundraising

• Manager Performance: Unknown

• Fund Size: Too small

• Relationship: Management team forming

• Characteristics: Brand established -> loyal LPs

• Manager Performance: Top-quartile performer

• Fund Size: Appropriate

• Relationship: Aligned interests

• Characteristics: LPs leave and are replaced

• Manager Performance: No longer top performer

• Fund Size: Too large

• Relationship: Spinout (of GP managers) or made it (only own capital)

• PE management company / GP goes public

• PE funds with portfolio companies remain private limited partnerships

• Use legal structures that reduce duties to non-insider shareholders

• Limit public board power -> no control over PE activities

• Raise permanent capital

• Liquidity for partners

• Use shares as acquisition/compensation currency

• Share price tied to public instead private market

• Increased regulations

• Misalignment long-term private & short-term public investments

• Low diversification -> concentrated portfolio companies

• Strategic Merger

• Buyout-to-buyout deal

• IPO

• Direct listing

• Another LBO (leveraged recapitalization)

• SPAC

• Sell portfolio company to corporate buyer

• Most common exit for VC & BO recently

• Sell to another buyout firm -> secondary BO

• Increased activity recently

• Public listing of company using underwriter bank

• Most common exit for VC & BO in 1990s

• Public listing without underwriter

• Existing shares are sold directly to market

• New debt while current owners retain control

• Allows partial cash-out without full exit

• Sell cpmapny to listed SPAC

• Faster route to public markets than IPO

• SPAC = public company -> public listing as outcome

• SPAV = private vehicle -> private transaction

• IPO = underwriting bank prices shares -> buys them from company -> resell to investors

• DL = No underwriters setting price / selling shares -> existing shares are sold directly with price stting by market

• Public listing using underwriter

• Activity down 60% since 2002 -> Regulations: Sarbox

• Timing dependent on market

• Prospectus & roadshow (done by underwriter)

• Financial projections not allowed

• Lockup periods of 90/180 days for exist. shareholders

• Median time to IPO for VC has increased

• Existing private shares trading on public exchange

• Shareholders selling shares

• Faster and cheaper than IPO

• No lock-up period

• Ability to raise new capital since Dec 2020 -> new shares can be issued during DL

  
  

• No underwriter price support

• Requires strong brand recognition (e.g., Spotify)

• Publicly listed shell company

• No operations when created

• Purpose: buy private company and take public

• Set up by VC/PE/Hedge Fund Firms

• Sponsors raise capital and select acquisition target

• Public investors provide capital before target is identified

• 2 years to find target and purchase

• Capital returned to investors if no deal ovvirs

• SPAC merges with private company

• Private company assumes public listing

• Requires shareholder approval

• SPACs separate listing from operational business disclosure

• SPAC sponsors can share financial projections during De-SPAC

• No details of target necessary at SPAC IPO -> faster listing

• SPAC IPO issues unit at $10

• Each unit = common share + warrant

• Right to buy extra shares at fixed price ($11.50)

• Exercisable to 5 years after De-SPAC

• Forced to convert if shares trade at certain price for certain period

• Dilutive -> warrants are issuance of new shares

• If no target found -> investor receives paid-in ($10)

• Investor can redeem shares of merger (vote yes for deal but ask for cpaital back)

• Investors may keep warrants after redemption

• Downside risk limited (capital protected)

• Upside remains through warrants

• Dilution -> median cost to company 50%

• Early Stage

• Late Stage

• Pre-seed capital

• Seed capital

• Series A round

• Private entrepreneur investing in early-stage opportunities

• Amount: $250k-$750k

• Stake: 5%-10%

• Use of Funds: Idea

• Amount: $2M-$5M

• Stake: 15%-20%

• Use of Funds: MVP, Customer, Business Plan

• Amount: $5M-$10M+

• Stake: 10%-30%

• Use of Funds: Beta testing, Team & services building, generate revenues

• Series B-D

• Beyond

• Amount: B -> $20M & D -> $1bn

• Stake: 5%-10%

• Use of Funds: Working capital, expansion, IPO prep

• Capital increases -> valuation rises -> dilution falls -> focus from idea to product to revenue

• Median VC Fund returns are modest

• KS-PME < 1 -> VC underperforms public markets (Kaplan-Schoar Public Market Equivalent)

• Mean returns are much higher -> positive skew

• Most VC deals fail or earn little return

• Home runs generate most returns

• Diversification reduces upside in VC

• First-time VC funds perform well

• Putperform second-quartile established managers

• Strong performance in top & bottom quartile funds

• Top funds attract better deals, talents & investors

• Weak manager struggle to raise follow-on funds -> reduces competition

• Funds deploying capital more quickly in year 1 tend to underperform

• Reverse only in certain market conditions (rapid deal flow)

• GP skill and experience

• Fund Size

• Network

• Homogeneous Network

• Diversity

• Higher experience and industry knowledge

• Higher VC returns

• Increased fund size -> lower returns

• Strong network with other VCs

• Improves deal access and returns

• Deals amongst friends lowers retuns

  • Same ethnic

  • Same education

  • Same career background

Gender-diversity improves returns

• Risk Premium -> taking higher risk (power law) & illiquidity premium

• Sources of risk

  • Business risk

  • Liquidity risk

  • Specific risk (idiosyncratic)

• Access to successful GPs

• Diversification across

  • Vintage

  • Industry

  • Geography

• Used to value early-stage companies

• Focus on growth potential than current profits

• VC Method

• TAM

• Value company using projected exit EBITDA

• Used as proxy for pre-tax cash flow

• (EBITDA * EBITDA Multiple) / (1+IRR)^T

• Estimates maximum revenue opportunity

• Industry revenue * expected market share * revenue multiple

• Required return (e.g., 50% IRR p.a.)

• 50%-70% -> early-stage ventures

• 30%-60% -> later-stage ventures

• Illiquidity -> exit for early-stage uncommon

• VC spend lot time to early stage ventures

• Adjustment to founder’s overconfidence

• Pre-Money Valuation: value of company before new investment

• Post-Money Valuation: value of company after new investment

• Pre-Money Valuation + Investment

• Investment / Post-Money Valuation

• Business plan as investment consideration

  • Roadmap for milestones for future funding

• Option view -> Follow-on funding based on new information

• Continuous investment proposition

• Relationship with founder

• Avoiding dilution

• Early-stage only (no follow-on; high dilution risk)

• Early + follow-on funding

• Separate funds for early- & later-stage

• Clarify fund risk/return profile to LPs

• Ensure capital reservation for follow-on’s

  • Reserves set via fixed rules or Monte Carlo Simulations

• Traditionally -> convertible preferred stock

  • Senior in capital structure

  • Fixed dividend; no voting right

• More Recent: SAFE

  • Simple Agreement for Future Equity

• Right to receive equity in future -> SAFE converts into equity by issueing new shares to holder

• Conversion at favorable valuation

• Triggered by future funding or sale

• Between VC and BO

• Companies are post VC Stage -> not mature for BO

  
  

• High growth / scalability

• Established product / business model

• Expand market shate

• Minority stake

• Founders / management retain control

• Focus on growth -> not cost-cutting

• Newest form of PE investing -> traced to 1990s

• Significant growth since 2014

  
  

• Companies stay private longer

• Differentiated return profile vs VC & BO

• Greater acceptance from insti investors

• Typically Preferred equity

• May also use convertible notes or warrants

• Low debt use to preserve cash for growth

• Business Development

• Marketing expansion

• Prepare exit (e.g., IPO)

• Similar to VC Method -> focus on growth potential

• Based on

  • Comparable transactions

  • Revenue / earnings multiples

• (forecast revenue (t) * revenue multiple ) / (1 + IRR) ^T

• Limited control

• Market risk

• Execution risk (value creation plan)

• Valuation risk (overpay)

• Liquidation preferences

• Valuation adjustments -> milestones

• Negative controls -> able to block decisions

• Redemption rights

• Investor’s right to get capital back

• Consideration of

  • Triggers

  • Redemption Value

  • Default Remedies

  • Sources of Funds

• Time-Based

• Performance -> milestones not met

• Covenant-Breach

• Paid-In + Fixed Return

• Pre-agreed Multiple

• Fair Market Value

• Actions investor can take if company fails obligations

  • Springing Board -> investor appoints board majority

  • Forced sale of company

• Legally available Funds

• Forced Sales

• Promissory Notes -> IOU; written letter with debt features

• Acquisition of controlling stake in established company

• Typically mix of equity/debt

• Improve operations / cash flows

• Capital structure omptimization (financial engineering)

• Operational efficiency optimization

• Market Efficiency -> segmented / informationally inefficient

• MBOs as Breach of Fiduciary Duty

• Incentive Issues -> perverse incentives for MBI

• Markets segmented and informationally inefficient

• Buyouts can exploit mispricings

• Risk that management buys company too cheaply

• Potential breach of duty to public shareholders -> information asymmetr

• External managers may have misaligned incentives

• Examples include golden parachutes (payouts perfromance regardless) or deal-driven pay

• MBO

• MBI

• Buy-in MBO

• Secondary Buyout (sponsor-to-sponsor)

• Leveraged buyout led by existing management

• Management stays after transaction

• Leveraged buyout led by external management

• New management in control after transaction

• Combination of MBO and MBI

• Mix of existing and external management

• Sale of company to other PE Firm

• Sponsor-to-sponsor

• Traditional LBO

• Operational efficiency buyouts

• Carve-Outs

• Spinoffs

• Growth BO

• Buyout-to-buyout

• Turnaround

• Buy-and-build

• Debt raised against stable company cashflows

• Debt paid down over deal life

• Diverse shareholder group replaced by LBO firm

• Focus on improving profitability and efficiency

• PE firm buys division from company

• Entrepreneur stimulator -> frees management to focus and innovate

• Break up inefficient conglomerates (large company with different businesses)

• Unlocks value from separate businesses

• Target company has above-average growth

• Combines control & expansion

• Portfolio compny sold from on PE firm to other PE firm

• Sponsor-to-sponsor deal

• Targets underperforming / distressed firms

• Focus on operational and financial recovery

• Growth through mutliple acquisitions

• Value creation via scale and synergies

• Structured similar to VC funds

• Closed-end funds with GP-LP model

• Management fees

• Incentive fees

• Transaction, breakup, divestiture & director fees

• Lower than in VC

• Strong control & icentive alignment with management

• LBO auctions -> multiple PE firms bid for target

• Club deals -> PE firms jointly acquire target

• Interest tax shield

• Reduced regulatory scrutiny

• Strategic focus

• Stronger stakeholder alignment

• EBITDA / (discount rate - growth in EBITDA after exit)

-> EBITDA / (r-g)

• Strong governance standards

• Governance practices persist after re-listing

• Creates discipline for inefficient public companies

• Discourages management empire building

• Private sale of securities by a public company

• Private / registered common stock

• Preferred stock / convertible debt

• Equity line of credit (ELC) -> sell shares over time

• Issuer

  • Faster/cheaper than public offering

  • Less market disruption

• Investor

  • Can take large stake

  • Often at discount

• Converts into a fixed number of shares

• Fixed conversion ratio

• Floating conversion ratio

• Toxic PIPE: lower share price → more shares issued → potential death spiral

• BDC -> Business Development Companies

• Exchange-traded closed end funds

• Way for public investors to access private credit / equity investments

• Lend to or invest in growing private firms

• Distribute most of income to shareholders

• No corporate tax on distributed profits

• Trade at premium/discount

  • (Market price / NAV) - 1

• High correlation with small caps

• No effective diversifiers

• Underperform Public Equities

• Management quality is critical

• PE funds with very long lifespan (15+ yrs)

• Fewer transactions / lower DD costs

• Deferred (paid later) capital gain taxes

• Flexible exit timing

• Increased illiquidity

• Lower IRRs

• Delay in exits -> higher/longer carry

• Limited opportunities