International Private Equity

Eli Talmor, Florin Vasvari

• Publisher: Wiley
• Year: 2011
• ISBN:
  9781119973881
• Edition: 1
• Topic: Business
• Subtopic: Private Equity
• Index: Business

Bringing a unique joint practitioner and academic perspective to the topic, this is the only available text on private equity truly international in focus. Examples are drawn from Europe the Middle East, Africa and America with major case studies from a wide range of business sectors, from the prestigious collection of the London Business School's Coller Institute of Private Equity. Much more than a simple case book, however, International Private Equity provides a valuable overview of the private equity industry and uses the studies to exemplify all stages of the deal process, and to illustrate such key topics as investing in emerging markets; each chapter guides the reader with an authoritative narrative on the topic treated. Covering all the main aspects of the private equity model, the book includes treatment of fund raising, fund structuring, fund performance measurement, private equity valuation, due diligence, modeling of leveraged buyout transactions, and harvesting of private equity investments.

PART 1

Overview and fund-level analysis

Chapter 1

Introduction and overviewa

1.1 INTRODUCTION

In recent years the profile of the private equity industry has increased dramatically. While the industry has been actively investing in companies across a wide range of industries for several decades, the combination of astute buying by private equity funds focused on buyouts in the early part of the last decade and the extremely liquid credit markets of 2004–2007 fueled some impressive exits. Similarly, private equity funds focused on venture investments had very successful exits in the late 1990s. These exits helped to substantially increase the profile of the industry.

Over the last 20 years or so private equity has grown to become a sizable asset class at its peak, responsible for up to a quarter of global M&A activity and as much as half of the leveraged loan issues in the capital markets. At the top of the last cycle, private equity funds found themselves able to acquire very public assets and seemed to be able to deliver extraordinary returns, both for their investors and for their managers. This “institutionalization” of private equity saw its profile rise substantially with a number of commentators focusing on this “new” industry.

Towards the end of this decade the industry, like every other, had to weather the financial crisis. During the crisis a number of new private equity investments fell dramatically, despite the historically high level of capital commitments made to private equity funds. The prevailing economic uncertainty combined with a very significant reduction in the amount of leverage available to dealmakers combined to severely restrict new-deal activity. The global financial crisis and associated recession also led to a sharp slowdown in fundraising.

Despite the considerable challenges, the economic environment produced a surprisingly small number of private equity–backed business failures. Many portfolio companies benefited from the active, hands-on involvement of their private equity owners. As a result, private equity portfolio companies managed to weather the economic downturn through a combination of revenue protection, production efficiencies, cost cutting, and careful working capital management. Also, lower commodity prices, lenders willing to restructure the debt, and new opportunities to refinance the debt due to a strong high-yield bond market have helped to mitigate financial pressures.

Indeed today it may be that the private equity industry has become a victim of its own success. The exceptional performance of the early part of the last decade certainly attracted ever more capital into the industry and some of it has been deployed to acquire large and visible companies. Thus, for the first time, private equity has been brought into the public arena and, now that it is there, it is likely to remain. In the future it seems clear that the industry will have to communicate more effectively with the various stakeholders and will be subject to increasing levels of external scrutiny and regulation. The calls to regulate the industry have increased, mainly due to the perception that the industry has contributed to the severity of the credit crisis. Such initiatives as the Alternative Investment Fund Manager (AIFM) regulations may prove to be the beginning of an increasingly onerous regulatory process.

However, despite the challenges that the industry faces (not least of which, the difficult economic environment that seems likely to persist in the medium term in most of the Western world), many within the industry retain their high hopes for the future.

Background

Private equity is the name given to that part of the asset management industry where investments are made into securities which are usually not quoted in the public markets. Private equity investments are normally made through special purpose fund structures of finite life which are established to follow specific investment strategies. These funds provide capital to a wide array of companies, ranging from business startups to very large and mature companies. One of the reasons the private equity industry exists is that, in many cases, companies have needs for capital which, for various reasons, cannot be met from the public markets. Investors that provide capital to private equity funds invest in an asset class that entails relatively high risk and high illiquidity in what remains a largely unregulated market.

At its highest level, the private equity industry can be subdivided into buyout and venture capital funds. Both buyout funds and venture capital funds share similar organizational structures in terms of their management fee structure and longevity. However, they are quite different when it comes to their investment strategy. Buyout funds usually focus on established and mature companies rather than young businesses and use debt as well as equity financing. They also tend to be larger in size than the venture funds. Venture funds focus on startups, young and high-growth companies, and do not use debt capital when providing financing. In both cases the general partners (or managers of the funds) normally play an active role in the lives of the portfolio companies that they invest in, often taking seats on the management board of portfolio companies and monitoring the delivery of an agreed strategic plan. Typically, a successful investment would see the execution of this strategic plan and the eventual exit of the private equity owner after between 3 and 7 years.

Private equity funds differ significantly from other investment funds found in the public markets in that the typical concentration of ownership allows the investor a far higher degree of control. In essence, private equity fund managers seek to influence the companies they invest in and, in the case of buyouts, choose an optimum capital structure. Prior to investing they conduct extensive due diligence and have significant access to the views of management of these companies. It could easily be argued that private equity funds operate with much better information and stronger controls over portfolio companies than, for example, mutual funds holding quoted equities.

Worldwide, private equity funds manage approximately USD2.5tn of assets and committed capital of which the vast majority is in buyout funds (CityUK, 2010). Some of the largest investors in the asset class are pension funds (who in turn supply the capital to the various special purpose vehicles that actually make the underlying investments). Leveraged buyout transactions have grown significantly over the last two decades. In 1991, new buyout transactions were USD10bn and by the beginning of 2006 they had reached USD500bn. This annualized total was equivalent to 5% of the capitalization of the U.S. stock market (Acharya et al., 2007). This growth was fueled by a virtuous circle of supportive economic environment, favorable credit terms, and continuing demand from investors for steadily larger private equity funds.

Origins of private equity

The history of private equity as an asset class goes back to before the Second World War with the beginning of angel investing in the 1930s and 1940s. Wealthy families, such as the Vanderbilts, Rockefellers, and Bessemers provided capital to private companies as angel investors. One of the first venture capital firms, J.H. Whitney & Company, was founded in 1946.

The early seeds of the venture capital industry can be traced to 1946 with the founding of two venture capital firms: American Research & Development Corporation (ARDC) and J.H. Whitney & Company (Wilson, 1985). General Georges F. Doriot, an influential teacher and innovator at Harvard University is known for his role in the formation of ARDC which raised outside capital solely for investment in companies. In its 25-year history, ARDC helped fund more than a hundred companies and earned annualized returns for its investors of 15.8% (Fenn et al., 1995; Kocis et al., 2009). ARDC is credited with the first major venture capital success story when its 1957 investment of USD70,000 in Digital Equipment Corporation increased in value to over USD355mn after the company’s initial public offering in 1968.

In 1958 early venture capital got a boost from the U.S. government when small business investment companies (SBICs) were licensed. This license gave these finance companies the ability to leverage federal funds to lend to growing companies. SBICs became very popular in 1960s. During this period, the development of limited liability partnerships for venture capital investments took place. In this arrangement corporations put up the capital, with a few percentage points from this capital paid every year for the management fees for the fund. The remaining capital was then invested by the general partner in private companies.

However, the big boost for venture capital in the U.S. came in the 1970s. The first boost was the reduction of capital gains tax. Despite inroads made by SBICs and the reduction in capital gains tax, total venture capital fundraising in the U.S. was still less than USD1bn a year throughout the 1970s. The second boost was from the U.S. Congress in 1974, when it enacted the Employee Retirement Income Security Act (ERISA), a set of pension reforms designed to help U.S. pension managers into more balanced custodianship. This act was clarified in 1979 to explicitly permit pension funds to invest in assets like private equity funds. Consequently, in the late 1970s and early 1980s a few pension funds added a small amount of venture capital to their portfolio and a few university endowments joined in (Metrick, 2007).

The first of today’s big private equity firms, Warburg Pincus, was formed only in the late 1960s, and had to raise money from investors one deal at a time. Another large private equity firm today, Thomas Lee Partners, was founded in 1974 and was among the earliest independent firms that focused on the acquisition of companies with leverage financing. KKR was another early firm and managed to successfully raise the first institutional fund of investor commitments in 1978. By the late 1980s private equity had grown big enough to be noticed by the general public, but it made hostile headlines with a wave of debt-financed “leveraged buyouts” (LBOs) of big, well-known firms. In the late 1980s, funds often borrowed massively to pay for buyouts, many of which were seen as hostile by the management of the intended targets. When KKR bought America’s Safeway supermarket chain in 1986, it borrowed 97% of the USD4.8bn the deal cost (Bishop, 2004).

1.2 CYCLICALITY OF THE PRIVATE EQUITY INDUSTRY

Private equity activity appears to experience recurring boom and bust cycles that are related to past returns and...