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32 Imaging Spectrum August 2007 International Imaging Technology Council www.i-itc.org

How Private Equity Really Works (Part 1 of 2)

by Martin Stein, Managing Director, Blackford Capital, Tony Kiehn, Managing Director, Blackford Capital and Jennifer Danzi, Marketing Analyst, Blackford Capital

everaged buy-outs (LBOs), in which an existing company is acquired using a combination of debt and equity, totaled just under $60 billion of transactions in 2002. In 2006, LBOs accounted for more than $400 billion of transactions. In the first half of 2007, there have been over $335 billion of LBO transactions. Looking forward to 2008 and beyond, one might assume that the volume of LBO activity will only increase. However, LBOs are cyclical and the current cycle, the biggest ever, is bound to come to an end given the potential for increased interest rates, proposed tax increases, and increased competition.

public as well as a host of players involved in some form of transactional events, financial solutions or participation in the capital structure of businesses. Generally, private equity refers to leveraged buyouts, seed investments, venture capital, angel investing, growth capital and other various forms of financing or investing. Private equity can be categorized by the size of investment, type of investment, target rate of return, investment horizon, source of capital, number of investments per year and location within the capital structure, among other factors. There are approximately 1,000 to 2,000 private equity firms within the United States with approximately $200 billion of uninvested equity capital available for acquisitions and investments. Most private equity firms manage capital from both wealthy individuals and from institutions. Two of the largest categories of private equity firms are venture capital firms and LBO firms. Venture capital firms provide financing to start-up businesses that need seed financing to grow. LBO firms acquire existing businesses with a combination of debt and equity and work aggressively to improve the value of the companies they acquire over a three- to seven-year period.

Regardless of whether LBOs are at their peak today, tomorrow or yesterday, savvy business executives are well-served knowing more about the mechanics of private equity firms and how a leveraged buyout works. Several private equity groups (PEGs) have made forays into the compatible imaging supplies industry in recent years (Hyde Park Holdings, Key Capital Partners, Stonehenge Capital, Kayne Anderson and Blackford Capital, among others), several more have investigated the industry and, no doubt, a few more will still contemplate making future investments. In a two-part series, this article will provide entrepreneurs and business owners with a basic understanding of the mechanics of a leveraged buyout, offer information to both buyers and sellers on the process of a transaction and articulate the philosophy or point of view of a private equity firm as they evaluate any given transaction. What Is Private Equity? Private equity, as its name suggests, is private, which means it is not subject to ownership or results reporting, SEC filings (except when acquiring public entities) or other public disclosure regulations. Interestingly, two of the largest private equity firms (Blackstone and KKR) have recently completed or announced initial public offerings. As its name also implies, private equity typically involves equity (not debt) investments. However many, if not most, private equity firms also provide debt financing for businesses. There are a variety of different types of private equity transactions the term is used loosely to describe any capital providers that are not

Copyright 2007 Imaging Spectrum and its licensors.All rights reserved.

Martin Stein is the managing director of Blackford Capital, a private equity firm focused on middle-market acquisitions, and serves as treasurer on the executive board of the International Imaging Technology Council. Previously, he served as president of Quality Imaging Products. Stein has received numerous industry leadership awards and has substantial private equity, investment banking, operations and consulting experience. He has published several Harvard Business School cases and received his MBA from Harvard Business School and his BA from the University of Chicago.

Tony Kiehn is a managing director at Blackford Capital. Kiehn led Blackford Capitals sale of Rhinotek to Reliant Equity Investors. Kiehn has 10 years of experience working in Asia. He is a graduate of Harvard Business School and the University of Nebraska.

Jennifer Dazi is a marketing analyst at Blackford Capital. She currently attends Williams College and the London School of Economics.

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Feature Article IMAGING SPECTRUM MAGAZINE

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Private Equity Makes Headlines

eaders of the business press need not look far to find coverage on private equity. Fortune, Forbes, the Wall Street Journal, BusinessWeek, the New York Times, the Financial Times, and a host of other periodicals and newspapers have provided extensive coverage of private equity deals and firms over the past several years.The Blackstone Groups initial public offering was the largest IPO in the past five years and, arguably, one of the biggest business stories of the year, further highlighting the role private equity has come to play in the capital markets.

Private Equity is Bigand Growing Even Bigger As Chart 1: Private Equity Invested reveals, the private equity industry grew from $1 billion of equity invested in 1993 to approximately $15 billion in 2000 and was fueled, in large part, by the venture capital community. From 2001 to 2007, equity investments grew from $8.5 billion to $85 billion, fueled almost entirely by leveraged buyouts. Chart 2: The Biggest LBOs of All Time provides a dramatic demonstration of the recent rise of LBO transactions. The numbers are quite impressive. As of July 3, five of the biggest LBOs have been in 2007, four were in 2006, and one is the historic KKR deal immortalized in the legendary business book, Barbarians at the Gate. Articles in leading publications also point to the hot industry market (see sidebar,Private Equity Makes Headlines). Even more compelling is the data on Chart 3: Available Private Equity Capital. The total amount of uninvested capital has increased from $35 billion in 1990 to $180 billion today. Uninvested capital is used to denote the amount of available funds targeted to be investedthis number effectively represents the available capacity for transactions. Uninvested capital is a trailing figure (note the lowest level is in 2004, several years after the industry peak), but it is highly meaningful because it sets the stage for coming years. From 1990 to 1995, the amount of uninvested capital grew from $35 billion to $40 billion, approximately 3 percent per year. From 1995 to 2007, the amount of uninvested capital grew from $40 billion to $180 billion, approximately 70 percent per year. How Private Equity Works Private equity firms (both LBO and venture capital) are responsible for: Sourcing transactions Due diligence/completing investments Ensuring the success of the portfolio companies Exiting the investment

Blackstone IP is hot, hotGlobe and Mail, 6/22/07 US M&A Hits $1 Trillion in Record PaceFinancial News Online US, UK,6/28/07 Private Equity M&A In US Accounts For 35% Of Overall Activity, Up From 16% A Year AgoThompson Financial, 5/22/07 The 2000s M&A Boom Has ArrivedWall Street Journal, 6/27/06 Worldwide Strategic M&A Total $1.7 Trillion, A 69% Increase From Last Year Thompson Financial, 5/22/07 Private Equity Buyouts Soar,While IPOs and Exits SlowWall Street Journal, 7/14/06 Private Equity Buyers Are Creeping Into Non-Private Equity Sectors Such As Financials, Energy and Power, High Tech, and TelecomThompson Financial, 5/22/07 Blackstone Buyout Fund Hits Industry High $15.6 BillionWall Street Journal, 7/12/06 Attracting Private Equity Becomes A National Sport In EuropeNew York Times, 6/29/07

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Stein: How Private Equity Really Works (Part 1)

Each of these activities involves a very distinct set of skills and capabilities and will often have different team members involved. Sourcing Transactions There are between 4,000 and 8,000 middle market merger and acquistion (M&A) transactions completed per year in the United States. There are many more acquisitions by individual buyers. The middle market typically refers to transactions ranging from $10 million to $500 million. Most middle market transactions are not completed, so there are roughly 10,000 to 20,000 deals brought to market each year. As Chart 4: Total Number of US M&A Transactions Completed Each Year indicates, several hundred of these deals exceed $500 million in value. Approximately 1,000 of these deals are

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between $100 to $500 million in value and are called middle market deals. The vast majority of completed transactions are for less than $100 million. Deals less than $100 million in value are referred to as lower middle market. Additionally, an even larger number of acquisitions are never recorded because they occur between individuals or are unannounced. Private equity firms are responsible for roughly 20 percent of the transactions, while corporate buyers account or the remaining 80 percent. Chart 5: Sourcing TransactionsThe Deal Pipeline provides detail on the number of transactions a private equity firm will investigate to close on a new platform company. A typical private equity firm
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Feature Article IMAGING SPECTRUM MAGAZINE

International Imaging Technology Council

Once a private equity firm has determined that the deal fits its criteria (size, industry, growth, earnings, management team, etc.) and, more importantly, they believe the company has the potential to increase in value, the PEG will schedule a meeting with the management team to get additional information. PEGs may schedule meetings with between 5 percent and 50 percent of the firms that meet their initial criteria, depending upon how strict their criteria are. These meetings can be short or long, but in order to be productive they almost always involve the exchange of financial information. After a preliminary meeting, the PEG will evaluate the business, the industry, the management team, and the opportunity to increase the value of the business. If the PEG believes there is an opportunity to increase the value of the company and the shareholders have a reasonable expectation of value, the PEG will submit a Letter of Intent (LOI) based upon the feedback or direction from the shareholders (see sidebar,Interpreting an LOI). Typically, an LOI is a serious indication of a desire to move forward on the part of the private equity firm. Once an LOI is signedmost are non-bindingthe shareholders of the firm and the PEG will work through additional due diligence needs over a 60- to 120-day period to consummate the transaction.

(LBO) in the lower middle market might evaluate 1,000 to 3,000 deals per year (roughly one-quarter to one-half of the total deals brought to market, if the PEG is in touch with the right intermediaries such as bankers, accountants, and lawyers). Of those, between 5 percent and 10 percent (some 50 to 300) actually meet the firms criteria. The largest venture capital firms will see even higher numbers of deals from all of the start-up business plans and miscellaneous deals that are submitted to them. Larger LBO firms evaluating $500+-million-sized transactions will look at a smaller number of deals given the fact that their universe is smallerthere are only so many $500+ million deals per year.

Due Diligence/Completing Transactions Chart 6: A Typical Due Diligence Process for a Private Equity Firm delineates the seven mission-critical steps a PEG will need to complete during due diligence to consummate a transaction. From start to close, a well-managed transaction should take approximately 16 weeks. Private equity firms may take four weeks to present an LOI (although this process can certainly take longer) and then 12 weeks (approximately 75 to 90 days) following the signing of a LOI to complete a transaction. The schedule in Chart 6 assumes that the entire process (including initial introduction to the company) begins on Jan. 1.

PEG.The more information that the PEG has received, the stronger the LOI; the less information, the weaker the LOI. LOIs typically range in length from one to 15 pages. Short LOIs are not necessarily better or worse than long LOIs, although, as one might assume, the more details that are addressed in the LOI, the fewer the details that will need to be addressed later. LOIs often contain the following elements pertaining to the transaction:

Terms of the DealWhat assets are being acquired (if the deal is not a stock deal)? What liabilities are being assumed? Is there a working capital amount that is specified in the transaction? TimelineWhen is the transaction expected to close? Conditions to CloseWhat activities need to be completed in order to close the transaction? Are there any particular activities that would prevent a transaction from being closed? Must the business meet a certain performance requirement? Due Diligence ProcessWhat will occur during the due diligence process? Will employees, customers and suppliers be contacted? Will there be an environmen-

Interpreting an LOI
A Letter of Intent (LOI) is a non-binding indication of interest based on a private equity groups (PEGs) desire to acquire or make an investment in a particular company. LOIs are based on the information made available to the

Price of a DealWhat is the value of the entity? How is it being valued? Structure of the TransactionHow will the deal be structured? Cash at close? Payments over time?

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Stein: How Private Equity Really Works (Part 1)

Immediately following the signing of the LOI, the PEG will begin to complete the financial model/operational plan for the business. This process requires involvement by the companys management team and, potentially, its shareholders (frequently the same people in small enterprises). In this process, PEGs are looking to test their initial hypotheses about the potential future financial per-

formance of the business. PEGs will invest a significant amount of time in the financial analysis of the business, testing questions such as: RevenuesHow many current customers are there? What have the average sales of each customer been? What will they

tal audit? A legal audit? A financial audit? Operational and IT audits? Additionally, LOIs include the following components, which benefit both the PEG and the selling shareholders: Non-CompeteIf the owner is leaving the business (or may leave the business),PEGs will require a strong non-compete to ensure that the owner or shareholders do not receive money for the purchase of their business and then go out and directly compete with it.Clearly, most well-intentioned owners would never do this. ConfidentialityOften, a non-disclosure or confidentiality agreement has already been signed, yet the LOI will reaffirm the intention of both parties to keep the information exchanged confidential. LOIs that do

not come to fruition are best left undisclosed for all parties involved. ExclusivityPEGs will insist upon exclusivity for selling shareholders. From the point of view of a PEG, an LOI without a period of exclusivity is meaningless (for private transactions, public transactions have a different process). PEGs will spend anywhere from $50,000 to $1 million and 1,000 to 4,000 hours during the due diligence process. PEGs are much less inclined to make this investment in a transaction if the selling shareholders will not agree to a period of exclusivity while the PEG is making this investment. The first draft of an LOI should be perceived by selling shareholders as a starting point for dialog about a transaction. Most PEGs are open and willing to make modifica-

tions to an offer, based on the interests of the selling shareholder. By definition, LOIs are legal documents, which means they can be a little dry and unintentionally distancing for those not familiar with their language, structure and scope. If an LOI takes six or more drafts or two or more months to get negotiated,it often signals an unwillingness on the part of both parties to come to a mutually satisfactory agreement.Conversely,LOIs that are signed on the first draft within a day or two of being presented may not be particularly meaningful if both parties have not fully explored and discussed all of the components of the LOI.

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Feature Article IMAGING SPECTRUM MAGAZINE

be in the future? What are the sources of revenue? How is the product/service mix changing? Cost of Good SoldWhat is the cost structure for the business? How volatile are the costs? Will costs increase or decrease? What are the general trends for the business costs? What will affect material costs? What is happening with labor? Is labor increasing or decreasing productivity? Are there fixed costs? Are there economies of scale? Operating ExpensesWhat functions do the various management team members serve? How much are they paid for these functions? What is the structure of the sales team? How much advertising is required? Will additional investments yield increased results? Many PEGs will test the hypotheses for the business with rigorous analysis involving customers, vendors, employees and outside industry analysts. Typically, PEGs will require a substantial amount of data to complete their analysis. The company will need to be intimately involved in providing this information, and most PEGs (or buyers, for that matter), will not engage outside service providers until they have received, processed, and digested the information presented to them. This completes roughly the first third of the transaction. The second third of the transaction involves the outside service providers, such as accountants, lawyers, and other miscellaneous consultants. PEGs will select the number of outside consultants based upon the size of the transaction, the risk factors identified, the financial model, and the information accumulated during the initial due diligence. Acquirers of businesses can spend anywhere from

International Imaging Technology Council

$10,000 to $500,000 on this portion of the transaction. Generally, the outside consultants, lawyers and accountants are confirming the information that has been presented. All parties (buyers and sellers) want to ensure that there are no surprises. The final third of the transaction is financing and documentation. In most LBOs, PEGs will use debt both to satisfy the purchase price requirements of the seller and to increase their returns. Typically, sellers prefer a higher price than what equity returns alone would justify. As a result, buyers are forced to finance a transaction with debt. Similarly, buyers have certain thresholds for returns that require them to use debt to finance a transaction. If a buyer purchased a business entirely with equity, the performance of the business would need to be incredibly high in order for the buyer to achieve the necessary returns. Bank financing is not a complex process for a good business and a good private equity firm. Banks will provide debt based on assets and cash flows. Businesses with poor cash flows (low profitability) or limited assets will have difficulty getting financed. Additionally, businesses with less than $2 million of earnings before interest, taxes, depreciation and amortization (EBITDA) have difficulty getting financed because they are perceived as quite risky businesses. Larger deals are much easier to get done. Banks can take three to eight weeks to complete their own due diligence and agree to financing commitments. The documentation process involves the drafting, editing and signing of the asset or stock purchase agreement. The terms of the APA should roughly mirror the terms of the Letter of Intent. However, oftentimes during the due diligence process, buyers will identify financial costs, litigation, or other risk factors not previously disclosed that require an adjustment in the price and/or structure of the transaction. For example, the owner may have suggested that the financial system would need to be upgraded prior to the signing of the LOI, but he did not inform the buyer that the system was a $100 off-theshelf product that froze multiple times a day, did not permit monthly closings, and/or have a general ledger that was off by approximately $1 million, a material amount. Alternatively, the seller may have informed the buyer that the inventory was valued accurately, yet the buyer identified $2 million worth of non-virgin inkjet cores that were completely unusable and would need to be written off. Neither of these factors should be deal killers. However, they do represent material findings that could negatively impair the value of the entity being acquired. In addition to an asset purchase agreement, documentation may also, but does not necessarily, involve the following legal documents: Employment Agreementsa potential agreement with the chief principals remaining after the transaction that governs

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Stein: How Private Equity Really Works (Part 1)

the relationship post transaction between the acquirer and the principal. Non-compete Agreementa potential agreement that determines the length of time, after exiting the firm, that principals will not work in direct or indirect competition with the business they sold. Disclosure Schedulespotential documentation that supports the asset purchase agreement and provides details about the business. Schedules provide representation on inventory, accounts receivable, litigation and many other facets of the business. Loan DocumentsIf debt is used in the transaction, there will be loan documents that detail the loan provisions, covenants, terms, price and other variables associated with the loan. Miscellaneous AgreementsThere are other specific documents that may be required for both buyers and sellers to complete, including shareholder consents, board approval of the transaction, and assignment and assumption documents. Ensuring the Success of Portfolio Companies A typical private equity firm will manage between three and 40 portfolio companies at one time. Some larger, well-established funds could potentially have more portfolio companies, and select smaller funds with a more limited focus or a firm that was exiting its investments could manage fewer portfolio companies. Typically, private equity firms hold positions on the boards of their portfolio companies with quarterly in-person meetings. At the early stages of an investment, PEGs may look for weekly results reports and performance reviews. Assuming a portfolio company is doing well, PEGs will become less involved as the management team achieves the targeted results. PEGs are responsible for ensuring
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that management is successful, but they are not necessarily responsible for managing the business itself. If management is not doing well, PEGs may be required to find new management for a business. Given that PEGs look at an investment for a three- to seven-year horizon, with a usual target of five years, one year of missed results translates into a 20 percent setback (one year divided by five years) on the life of the investment. Every quarter represents 5 percent of the investment horizon. Therefore, a PEG is not likely to let more than several quarters of missed results transpire before needing to seriously evaluate the management team. Exiting the Investment After a company has achieved its desired results, PEGs will look to harvest their investment and ensure that they achieve the appropriate returns on the investment. To do so, the PEG will take the business to market and go through another sales process, similar to the process that brought the PEG to the acquisition in the first place. Again, this will typically occur three to seven years after the initial investment. Rarely do PEGs look to exit earlier than three years, and they will typically only remain longer than seven years if the company is performing quite well or if the company still needs to achieve certain results to meet the required equity returns of the PEG. Next months article will explore the top 10 misperceptions of buyers and sellers in private equity transactions.