Introduction to Private Equity

Cyril Demaria

• Publisher: Wiley
• Year: 2010
• ISBN:
  9780470711880
• Edition: 1
• Topic: Business
• Subtopic: Private Equity
• Index: Business

Introduction to Private Equity is a critical yet grounded guide to the private equity industry. Far more than just another introductory guide, the book blends academic rigour with practical experience to provide a critical perspective of the industry from a professional who has worked at many levels within the industry, including insurance, funds of funds, funds and portfolio companies.

The book looks at private equity from the point of view of the individual or the business. How is a private business valued? How is the acquisition transaction processed? What are the due diligence issues that should be considered before moving ahead? A valuable insight to a rather opaque market.

Introduction to Private Equity covers the private equity industry as a whole, highlighting its historical development in order to put its recent development into perspective. The book covers its organization, governance and function, then details the various segments within the industry, including LBO, Venture Capital, Mezzanine Financing, Growth Capital and beyond. Finally, it offers a framework to anticipate and understand its future developments.

It provides a balanced perspective on the current corporate governance challenges which are affecting the industry and draws perspective to understand the evolution of the sector, following one of its major crises.

Part I

What is Private Equity?

Whenever a company needs financing, two solutions come to mind: the stock exchange and bank loans. The stock exchange is a limited solution. It provides only access to funding for medium- and large-sized companies that meet specific criteria (sales figures, total of balance sheet, minimum number of years of existence, etc).

The conditions for taking out a loan are also strictly defined. Companies must prove their ability to pay back the bank in fixed instalments, which means that they must show a certain term of existence, stability of cash flows, healthy activity and also a limited existing indebtedness.

If neither the stock exchange nor banks finance business creation and development, then who, or what, does? Where does the money come from to finance the transmission or take-over of family businesses, for example? Or to restructure an ailing business? It is ‘private equity’ for that matter.

The expression ‘private equity’ was coined by reference to equity which is not listed and whose exchange is not regulated (Chapter 1). However, this definition only partly reflects the scope of action of private equity players, which has diversified and spread considerably (Chapter 2).

1

Private Equity as an Economic Driver: An Historical Perspective

Christopher Columbus convinced, after seven years of lobbying, the Spanish Kings (Ferdinand II of Aragon and Isabella I of Castile) to sponsor his trip towards the West. His ‘elevator pitch’ must have been the following: ‘I want to open a new and shorter nautical route to the Indies in the West, defy the elements, make you become even more powerful and rich, and laugh at the Portuguese and their blocs on the Eastern routes’ (see Cartoon 1.1).

Cartoon 1.1 A modern view of Columbus’s pitch to the Spanish Kings

Bottomliners © Eric & Bill Teitelbaum. All rights reserved.

He probably did not know by then that he was structuring a private equity deal (here, a venture capital operation). He was indeed, as his project combined these elements: financed by an external investor, a high risk, a high return potential and protection of this competitive advantage.

These elements form the common ground for all private equity deals (venture capital, development capital, leveraged buy-out, etc.). Another element lies in the ‘private’ characteristics of private equity deals negotiated privately between the parties: historically, they were made with non-listed companies.

Even though it is difficult to imagine whether, and how, Columbus did his risk/return calculation when assessing the viability of his project, we can assume that the risks borne by the operation were identified and that there was a plan to mitigate them - or at least sufficiently well identified to light enough candles in church.

The risks were high, but not unlimited (thus distinguishing his venture from pure gambling).

The prospect of reaching the Indies gave quite a good sense of what could have been the return on investment for the financial sponsors: the Spanish Kings and the private investors from Italy. Not only did the potential return exceed by far that which a conventional investment could provide, but the new route had a potentially disruptive impact on international commerce, giving the new born unified Spanish Crown a much needed mercantile boost.

This example illustrates the fact that private equity has always existed, in one form or another, throughout history. Examples of historical buy-outs are more difficult to identify, hence the focus of this chapter on venture capital. Buy-outs transfer majority ownership in exchange for cash and are generally friendly. Typically, buy-outs are conducted with insider knowledge. They have only recently started to become important, as they require sophisticated financial markets and instruments.

Historically, large buy-out operations were ‘barters’, with a strong real estate/commercial focus. This involved mainly swapping countries or towns for other ones. The state today known as New York was swapped by the Dutch West Indies Company (WIC) for Surinam, a plantation colony in northern South America, in 1667 (Treaty of Breda). This turned out to be a bad deal.

In 1626, Peter Minuit, then Director General of the WIC, acquired the island of Manhattan from the Indians and began constructing Fort New Amsterdam. In 1664, owing to commercial rivalry between the Dutch and the English, an English fleet sent by James, Duke of York, attacked the New Netherlands colonies. Being greatly outnumbered, Director General Peter Stuyvesant surrendered New Amsterdam, which was then renamed in honour of James. The loss of New Amsterdam led to the Second Anglo-Dutch War of 1665-1667. This conflict ended with the Treaty of Breda, under which the Dutch gave up their claim in exchange for Surinam.

The emergence of private equity as a dynamic financial tool required the interplay of (i) a supportive social, legal and tax environment, (ii) adequate human resources and (iii) sufficient capital. Together, these three conditions have developed slowly until they reached the current level of professionalism and formalism which characterises private equity. The clear identification and separation of the three conditions forming the ‘private equity ecosystem’ has been a continuous process, which is still under way.

The purpose of this chapter is to identify the key elements distinguishing private equity from other categories of investment. Private equity financing in the early days of venturing was an intricate mix of public policy, entrepreneurship and financing. The quest of European monarchs for greater wealth and power is emblematic for this mix, pooling public and private resources in order to identify and exploit sometimes remote resources (see section 1).

Public policies, entrepreneurship and financing became less complex and slowly gained autonomy. The public interest and policies were separated clearly from the King’s personal interest and will. Once the basic legal and tax framework had been established and adapted to the alterations in social and economic factors, the entrepreneur emerged as the central figure of the private equity ecosystem (see section 2).

Private equity investors developed a capability to identify them, providing capital and key resources to help with their venture and get their share of success. By gaining this know-how and expertise, those investors contributed to further professionalisation, developing strategies to mitigate risks and optimise returns (see Chapter 2).

1. POOLING INTERESTS TO IDENTIFY AND EXPLOIT SOURCES OF WEALTH

The fundamental objective of any rational investor is to increase his wealth¹ dramatically. Private equity offers investors the opportunity to finance the development of private companies and benefit from their eventual success. Historically, the raison d’être of those companies has been to identify and control resources, thereby developing the wealth of venture promoters by appropriation.

The main financial sponsor might have been a political leader, who would legally and financially ease the preparation and the execution of the venture for the benefit of the Crown and himself. The control of resources and the conquest of land motivated the launch of exploration ventures (a). Companies were created to support political efforts, thereby guaranteeing the demand for their product in exchange for their participation in a public effort to build infrastructures, create a new market and more generally encourage commerce and the generation of wealth. They could leverage public action (b). Apparently, conflicts of interest did not ring any bells at that time (see Cartoon 1.2).

Cartoon 1.2 A modern perspective on the old ages’ resolution of conflicts of interest in private equity...

© 2009 Wiley Miller and Universal Uclick. Reprinted by permission.

Often, private investors were complementing this public initiative, convinced by the pitch made by a person combining technical competence and know-how, with a vision and genuine marketing talent. This person would be identified nowadays as an entrepreneur - or the precursor of televangelists, when the marketing presentation becomes a seven-year sermon, in the case of Columbus.

(a) Identify, control and exploit resources

The quest to master time and space has given birth to pioneering public and private initiatives, bearing a substantial risk but also a potentially high reward. This reward was usually associated with the geographical discovery of new resources (land control) and/or effectiveness (new routes to the Indies, for example), allowing a better rotation of assets and improving the returns.

Columbus’s project supported a substantially higher risk than the equivalent and usual routes to the East. This project was deemed to be possible thanks to progress in navigation and mapping, and some other technical and engineering discoveries. In that respect, Columbus’s expedition was emblematic of the technological trend, as well as being political, religious and scientific; which he mastered so as to present his project.

The risks taken by Columbus were of two different kinds:

(i) Initial validation of theoretical assumptions, with substantial risks linked to the transition from a theoretical framework to an operational process.² Columbus’s prediction of the diameter of the Earth (3 700 km instead of 40 000) proved wrong, but his venture was successful in the sense that he reached an unknown new continent. This kind of outcome (refocusing the ‘research and development (R&D) effort’ towards a different outcome) occurs from time to time in companies financed by venture capital even today. Hopefully, not all venture-backed companies have a CEO who under-evaluates the effort to be produced by 10 times;

(ii) Execution of the four successive trips, with the presence of favourable winds and currents, the correct calculation of the time spent at sea with embarked supplies, navigation hazards (storms), morale of the crew and other operational aspects. Operational risks are generally financed by later stage venture capital and expansion investors.

For all of the reasons above, Columbus’s project was innovative in many respects. It was guided by ambition and a vision. It was designed to test concretely the validity of a certain number of theories, which would be of great reward if Columbus touched Indian ground after journeying to the West.

The high return potential was related to Columbus’s calculations, according to which the new nautical route could save a substantial amount of time (and risk) to reach the Indies despite the Portuguese land bloc. The return potential would be earned not from the initial trip itself, but from opening a new route for future trips to gather expensive goods (mainly silk and spices) and bring them back to Europe.

Another key element was that this new nautical route would have paved the way to developing a certain number of other new ventures using the route to gain other valuable goods. Columbus’s success would not have been a one-time pay-off but the source of recurring and long-term income.

The time horizon of the trip was calculated in months, which represents a long-term investment , and the pay-off would have been calculated in years. This represents another element that qualifies Columbus’s trip to the West as a private equity project.

Protection by the Spanish Kings of this advantage, by giving a legal right to the private sponsors of the project to the use of this new route (the historical equivalent of the current ‘barriers to entry’ in a given market) was a crucial element of the evaluation of the return on investments. Columbus was promoted to the status of ‘Admiral of the Seas’ by the Spanish Kings, and then to Governor once he succeeded in his venture. This meant that he just had to sit and wait for the profits to come, after making this initial breakthrough (see Cartoon 1.3).

Cartoon 1.3 A modern perspective of the royal advantages given to Columbus... Or the advantages of barriers to entry!

Bottomliners © Eric & Bill Teitelbaum. All rights reserved.

This pooling of the energies and resources of an entrepreneur (Columbus); of Italian private investors (representing 50 % of the pool of money) and of the Spanish Kings as a sponsor syndicate for the project, is another criterion for its qualification as a private equity project. Its commercial purpose, even if not exclusive in this example, is another.

As an additional incentive, Columbus would have received a share of all the profits made via this nautical route. More specifically, Columbus asked, aside from the titles and an official charge, for a 10 % share of the profits realised through the exploitation of the route to the West. He had option rights to acquire one eighth of the shares of any commercial venture willing to use the nautical route that he had opened. This kind of financial incentive (percentage on profits realised and the equivalent of stock options; in private equity this i...