Introduction to Private Equity

Venture, Growth, LBO and Turn-Around Capital

Cyril Demaria

• Publisher: Wiley
• Year: 2013
• ISBN:
  9781118571910
• Edition: 2
• Topic: Negocios y empresa
• Subtopic: Capital privado

This second edition of Introduction to Private Equity is more than an update, it reflects the dramatic changes which have affected an industry which is evolving rapidly, internationalizing and maturing fast. What is recognized as a critical yet grounded guide to the private equity industry blends academic rigour with practical experience. It provides a clear, synthetic and 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 approaches the private equity sector top-down, to provide a sense of its evolution and how the current situation has been built. It then details the interrelations between investors, funds, fund managers and entrepreneurs. At this point, the perspective shifts to bottom-up, how a private business is valued, how transactions are processed and the due diligence issues to consider before moving ahead.

Introduction to Private Equity, Second Edition covers the private equity industry as a whole, putting its recent developments (such as secondary markets, crowdfunding, venture capital in emerging markets) into perspective. The book covers its organization, governance and function, then details the various segments within the industry, including Leveraged Buy-Outs, Venture Capital, Mezzanine Financing, Growth Capital, Distressed Debt, Turn-Around Capital, Funds of Funds and beyond. Finally, it offers a framework to anticipate and understand its future developments.

This book provides a balanced perspective on the corporate governance challenges affecting the industry and draws perspectives on the evolution of the sector, following a major crisis.

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. They also have to provide some guarantees to banks, as collateral for the loan (i.e., if the loan is not paid, the bank will seize the guarantee, sell it and hence get paid back thanks to it).

Bank loans are actually being reshaped. This movement started with the switch in the US from an economy essentially supported by banks to an economy supported by financial markets.1 It has slowly permeated other countries. Today,2 banks seem on the verge of retreating further from certain financing operations, such as lending to small and medium-sized businesses. This movement is undertaken by banks under the pressure of new regulations (such as the Basel III Agreements), and as a consequence of the last financial crisis. This will pave the way for the rise of ‘non-bank finance companies’.

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? From ‘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).

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1. According to The Economist (15/12/2012), in the US, banks are responsible for 25 to 30% of total lending. In Europe 95% of total lending comes from commercial banks.

2. The Economist, 2012.

1

Private Equity as an Economic Driver

An Historical Perspective

Columbus: scientist, entrepreneur and venture capitalist

After seven years of lobbying Christopher Columbus convinced the Spanish monarchs (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.’

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

These elements form the common ground for all private equity deals (venture capital, growth/expansion 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 monarchs and the private investors from Genoa. 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 newborn unified Spanish Crown a much needed mercantile boost.

Private equity has always existed… just in a different form than today

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 Breda3). This turned out to be a bad deal.

Modern private equity emerged from large macro changes (and still requires them to emerge)

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 developed slowly until they reached the current level of professionalism and formalism which characterises private equity.4 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 1.1).

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 1.2).

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).

1.1 POOLING INTERESTS TO IDENTIFY AND EXPLOIT SOURCES OF WEALTH

The fundamental objective of any rational investor is to increase his wealth.5 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.

Private equity operations require a sponsor

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,6 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.

Private equity operations are symbiotic with public initiatives

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.

1.1.1 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.

High risk, high return potential

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; all of which he mastered so as to present his project.

The risks taken by Columbus were of...