Private Equity Know how to calculate NPV, IRR,DCF PE: unquoted, illiquid, high risk, expected returns excess

quoted market returns to compensate for illiquidity (VC and Buyouts) VC: successive, 100% equity, minority stakes in early growth co, often hi-tech co Buyouts: controlling equity investment (leveraged with debt) in mature companies, usually in traditional industries PE is important: create employment, make economy more active, (E square) VC economic role: support development of innovative growth business that cannot access traditional forms of capital, how: (IG -TC) 1. 2. 3. 4. VC: 1. start up and early stage investments a. High growth b. Usually high tech 2. Successive 100% investments over time a. 100k to 10 million b. Minority investment each time c. Founders begin with 100% ownership but diluted over time d. VCs may ultimately control the company 3. Very high commercial risk failures expected a. New products/services/business models b. Latent/changing needs c. New and/or shifting technologies d. Unexpected competitors e. Inexperienced management 4. 5-10 years investment horizon before realizes return VC invests in the application of emerging technologies that address commercially significant need or problems, rapidly growing business to sizable one, preferably business with proven management They hardly invest before company is formed, product is demonstrated, nascent management in place. The raw idea is usually bootstrapped by entrepreneur cash, friends and family, angel investors, company cash flow if it exists. VC is normally concentrated in few industries with application of technologies such as biotech, life science, IT, communication and electronics V C provide primary risk of capital many start up have negative cashflow VC ensure ongoing funding capacity multiple investment over the years Maintain long term support cope with inevitable ups and downs Adds Expertise

Lifescycles are: Development, Start up, Early Growth, Accelerating Growth, Sustaining Growth, Maturity (DSEA - SM) Return expectation by stages of investments: o o o o o o D 80% S 60% E 50% A 40% S 30% M 25%

Economics of Venture Capital investment In VC, there is no use of debt when investing Type of investors based on the stages of investments: (LV HS) 1. Lead investor, early stage investment focus early investment with entrepreneurs, large investment position at low valuation, superb networking and feel for markets/tech required 2. Value adding modus operandi - expertise in operating skills, financial acumen and outstanding market/technology knowledge, growth company accelerated 3. Home run mentality - build world class co, realize full value at exit 4. Strong backing of winners VC Skills set generally are: (Network, Tech, Vision, Judgement, Mentor, Decisive, Cool, Action) NeTV - JMDCA 1. 2. 3. 4. 5. 6. 7. 8. Good network to source deals Market/tech knowledge Strategic vision, sound business judgement and risk assessment Great people judgement Business mentor but without sentimentality Decisive with issues and awkward situations Cool under fire multi tasking ability Action orientation with long term perspective

Introduction to Buyouts: 1. Invests in typically mature co and traditional industries 2. Single up-front investment leading to 100% acquisition and full control, use of equity and debt 3. Management still allowed to buy 5-20% at favourable terms for incentive purposes 4. High financial risks failures are exceptions 5. 2-7 years before returns are realized Economic rule of buyout unlock value in companies that are not fulfilling their potential by: 1. Driving fundamental change in

a. b. c. d. e. f.

Business strategy Management motivation, capability and effectiveness Company culture Operating efficiencies Utilisation of assets Capital structure

To create value in enhanced cash flow, and improve competitive position How can buyout add value to the economy: 1. 2. 3. 4. Facilitates private market for corporate restructurings Improves efficiency in listed markets Optimises global capital allocation through creative destructive Possibly the only source of capital to save failing companies

Typical target of buyout: 1. Adequate and reliable cash flow 2. Opportunities to improve performance through: a. Strategic repositioning b. Improved marketing/product offerings c. Better operational efficiency d. Loosening of corporate constraints e. Redeployable, non-core assets available f. Underperforming/poorly incentivised management 3. Undervalued companies or distressed/forced sale 4. Significant asset to collateralise loan 5. Non-cyclical industrial sectors and stable companies without rapidly changing technology Why the focus have been misplaced recently: 1. Overly comfortable on cash flow financing and reduced the importance of asset collateralisation 2. Financial engineering - less steady and reliable cash flow required, longer debt repayment, unsustainable purchases multiple 3. Lenders are used to accept covenant lite terms and very junior positions in debt hierarchy 4. Buyout firms become comfortable on taking positions on troubled companies without the necessary expertise, this include tech companies Gross Capital Gain > ROE year x ROE year 1 Gross investment multiple > ROE year x/ROE year 1

Buyout Skill set SOAP-DNS 1. Strategic and Operational expertise

2. 3. 4. 5.

Savvy buyers at Auction Project management stills Love for Deal making and Negotiations Stamina and ability to stomach the stress

PE investment life cycle source potential deals, evaluate and negotiate investment, monitor companies and add values, realize value by exiting (S, E, M&A, E) Evaluation can be done by due diligence of the target company: 1. Identify real underlying performance 2. Assessing growth and profit improvement opportunities 3. Isolating key risks market, operational, tech, managerial, facilities, contractual, environmental 4. Understanding business plan assumptions market, competitors, customer checks 5. Developing 100 day and full potential plan to capture opportunities and mitigate risks How to evaluate VC potential opportunities: 1. 2. 3. 4. 5. Customer Management team evolution Big growing markets potential for growth Sustainable competitive edge Discipline to identify/eliminate the known unknowns: tech, revenue/expense model, customer need 6. Clear exit plan 7. Relaxed about financial forecasts indicator of how management think 8. Trust in gut feel Potential conflict between investors and entrepreneurs can be mitigated by 1. Equity share structure/liquidation preferences encourages entry of new investment in difficult situation 2. Covenant, control terms interest coverage ratios, voting rights, non-compete clauses, milestones 3. Anti-dilution ratchets in share subscription provides dynamic allocation of control and protect investors share price control over to VC if things do not go well and vice versa 4. Exit provision How to add value in VC: 1. 2. 3. 4. 5. Building management team Challenging and redirecting strategy Opening customers doors Mentoring, coaching Facilitating acquisition/mergers

6. Sustaining financing free investment banker How to add value in buyouts: 1. 2. 3. 4. 5. 6. Cash focused Shareholder value oriented business plan Sense of urgency and focus on basics Better management team Reconstitute chairman/board with relevant experience Ownership culture in depth involvement from management and owners

How to value private equity: 1. Industry comparables Apply historical price to multiple financial ratio (PER, EBIT/EBITDA, Sales, R&D expenditure, website clicks) Must be careful when use this potential apple orange problem 2. Target of return approach IRR, values in future How much can I afford to invest if I expect the company to be worth 20 mil in the next 5 years? What share of the company I must own to realize xx IRR? If I accept the return proposal, what return will I make? Example of Target of return approach Three year EBIT = 5.9m, New VC investment of 3m, company has no debt, 45% Target IRR (Year 3 discount factor = 3.05), Historical EBIT Multiple = 16.5X , Founders currently own 100% of total shares (total shares = 1m), Management team has options that can be exercised at the end of Year 3 and will give them 20% of company at that time 1. Required Year 3 value of VCs investment (45% IRR) = 3m x 3.05 = 9.15m 2. Year 3 Enterprise Value = 5.9m x 16.5 = 97.4m (= Total Equity Value since there is no debt) 3. Year 3 value to VC after options exercised = 97.4m x 80% = 77.9m 4. Required VC ownership (to achieve 45% IRR) = 9.15m/77.9m = 11.7% Implied Post-Money Valuation = 3m/0.117 = 25.6m Pre-Money Valuation = 25.6m - 3m = 22.6m

5. Number of new shares issued to VC x/(1m + x) = 0.117 x = 132,653 shares

6. Price of new shares = 3m/132,653 = 22.62 per share

Chapter II

Adjusted Present Value (APV): NPV of CF from assets + NPV from side effects of financial structure Equity discount rate: risk free rate * (asset beta) * equity market premium Asset beta: Terminal value: equity beta * percent equity in capital structure

3. DCF analysis

Envy ratio: end cash flow for buyout / end cash flow for management Gross vs net proceeds All proceeds after Portfolio Company Management Share of the Equity) Dont forget Annual Management Fees have already been extracted from the fund Less, GENERAL PARTNERS CARRIED INTEREST (20% of Capital Gain - unless LPs return is below Hurdle Rate) _____________________________________________________________________ Equals NET PROCEEDS to Limited Partners 100m Fund 10 Year Life - 8% Hurdle Rate Year 10 Gross Proceeds (Gross Proc) Less Investment Gross Capital Gain Less Hurdle (Gross CG) 300 (100) 200 (80) 120 40

(10 x 8% x 100)

Available For Carry Pro-Forma Carry (20% x Gross CG)

Actual Carry to GP

40

Net Proceeds to LPs (Gross Proc - Carry) Net Capital Gain to LPs (Gross CG Carry)

260 160

100m Fund 10 Year Life - 8% Hurdle Rate Year 10 Gross Proceeds (GrP) Less Investment Gross Capital Gain Less Hurdle (GrCG) 300 150

(100) (100) 200 (80) 120 40 50 (80) 0 10

(10 x 8% x 100)

Available For Carry Pro-Forma Carry (20% x GrCG)

Actual Carry to GP Net Proceeds to LPs (GrP - Carry) Net Capital Gain to LPs (GrCG Carry)

40 260 160

0 150 50 10

GP Carry Deficit Private equity commitment and cash flows 1. 2. 3. 4. 5.

Allocated funds Committed funds Capital calls/draw downs Invested funds Distributed funds investor receives distributions or dividends from the invested fund

PE fund was valued at costs but now they are valued at fair value which is mark-to-market PE fund valuations are accurately valued at initial investment and exit What drives IRR? Achieved investment multiple (exit proceeds/investment) and time (investment to exit) Measuring PE fund can be done with J curve and valued by actual realized values vs estimated values of unrealized companies in the remaining portfolios Vintage year return cumulative year return of fund since inception. Why is this the best measure: 1. Economic cycles 2. General financial market conditions 3. State of PE market 3 key attributes of successful PE:

1. inefficient opportunity to achieve superior performance with best-of-breed funds 2. high persistence historical high return indicates possible high future return 3. low correlation with other asset classes portfolio risk can be reduced by adding PE fund what happened to PE in 2008? They were overcommitted, hence was thirsty was liquidity if gross capital gain < hurdle, then carried interest is zero. Perf fee carry is calculated after gross capital gain, then the difference (if +ve) will be what is available to be paid out to LPs, but if not whatever left is paid out. If gross capital gain> hurdle, carried interest is the difference * rate (pro-forma), if else, gross capital gain hurdle. Hurdle: with 3 different investment 8% * 100 * 10 years, 8% * 100 * 9 years, 8% * 100 * 8 years. Net investment multiple for the LP: ( gross capital gain carried interest to GP)/initial investment Fund with lower management fee and higher performance fee is better as management fee is deducted directly from the AUM. Key principle on diversified asset classes investing: concentrate on asset allocation rather than stock picking or market timing and use absolute return as the investment objective rather than beating the benchmark. Another point is to optimise risk adjusted total return by judicious diversification across asset classes that capture drivers of long term return: 1. 2. 3. 4. economic growth inflation deflation investment management skill (alpha)

Portfolio diversification can be done by: 1. return characteristics

2. 3. 4. 5. 6.

a. inflation sensitive vs deflation sensitive b. equity related returns vs fixed income c. correlation to economic climate/stock market geography time asset managers liquidity time frame currency

as well as regular portfolio rebalancing Commitment levels and liquidity 1. year 1-5 committed level via drawdown (capital calls) 2. year 3-10 distributions received 3. distribution often greater than drawdown Additional PE investment criteria: 1. 2. 3. 4. 5. 6. independent fund with top-quartile record clear evidence of value based approach GPs regarded LPs as partners Experienced team that have worked together before GPs have significant skin in the game (enough investment in the fund) Succession planning is evident