Business Knowledge for IT in Private Equity : A Complete Handbook for IT Professionals 9781906096717, 9781906096533

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Business Business Knowledge Knowledge for IT in for IT in Private Wealth Private Equity Management A complete handbook

A complete handbook forITIT Professionals for Professionals

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Essvale Corporation Limited 63 Apollo Building 1 Newton Place London E14 3TS www.essvale.com This is the first edition of this publication. All rights reserved Copyright © Essvale Corporation Ltd, 2010

Essvale Corporation Ltd is hereby identified as author of this work in accordance with Section 77 of the Copyright, Designs and Patents Act 1988

Requests to the authors should be addressed to: [email protected].

This book is sold subject to the conditions that it shall not, by way of trade or otherwise, be lent, resold, hired out or otherwise circulated without the author’s or publisher’s prior consent in any form of binding or cover other than that in which it is published and without a similar condition including this condition being imposed on the subsequent purchaser.

A CIP record for this book is available from the British Library ISBN (10-digit) 1906096538 ISBN (13-digit) 9781906096533

This publication is designed to provide accurate and authoritative information about the subject matter. The author makes no representation, express or implied, with regard to the accuracy of the information contained in the publication and cannot accept any responsibility or liability for any errors or omissions that it may contain.

Cover design by Essvale Design Team Printed by Lightning Source Ltd, Milton Keynes

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Preface

Preface Private equity funds are funds that are investors in the equity of companies not listed on stock exchanges. They also privatise public companies. The funds that these firms make available to companies are often comparable in size to those available to businesses whose equity is quoted on a stock exchange. Even though the credit squeeze may reduce the benefits from leverage and enhance the importance of underlying profit growth, private equity will continue to be an important factor in the world’s financial markets. This is the view taken by most experts on the sustained viability of the private equity industry. The uniqueness of the private equity industry’s relationship with IT stems from the fact that while they are users of IT in terms of systems within their organisations, they are also investors in or acquirers of IT companies. Business knowledge of the private equity industry is important for IT professionals and students for the following reasons: ■ A number of the bigger private equity firms are getting bigger and as a result will tend to use more technology in future. ■ Private equity firms generate substantial revenues each year from man­ agement fees and carried interest and hence can pay fairly high wages to the appropriately skilled staff. ■ Industry reports show that private equity is one of the subsectors of the financial services industry that could ride out the financial crisis, so a career in private equity IT can be both lengthy and gratifying. ■ Fund and investment managers in private equity firms are some of the brightest and most energetic people in the financial services industry and working alongside them can be of significant benefit to IT professionals. ■ Most private equity firms are relatively small-sized companies, meaning that IT staff will be exposed to a wide range of activities that can enhance their career prospects. Industry experts assert that private equity IT is a good career option in these uncertain times as most private equity funds have a 10-year lifespan and are not subject to huge outflows or redemptions as in other asset classes like hedge funds and equities. It is advisable to read this book in conjunction with Business Knowledge for IT in Hedge Funds and Business Knowledge for IT in Investment Management so as to gain a better understanding of investments and the commonality between private equity funds and hedge funds.

 PWC and AVCAL. (2006). ‘Economic Impact of Private Equity and Venture Capital in Australia’. A report available from www.avcal.com.au.

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Acknowledgements

Acknowledgements Essvale Corporation Limited would like to thank all authors and publishers of all materials used in compiling this publication. Also thanks to all the respondents to the research carried out to justify writing this publication. We would like to acknowledge Michelle A. Ringuette and Alvin Velazquez of Service Employees International Union to Pat Winfield of Bookworm Editorial Services, Barney Lodge of Lodge Consulting, the helpful staff of City Business Library and Idea Store Canary Wharf, the editors and support staff at Nielsen Book Data, Lucy Sharp of Lightning Source, Trey Smith of Ingram Digital ,Graham Morris and Vic Daniels of Hereisthecity.com, the staff of Amazon and other bookstores worldwide .Thanks for supporting Bizle Professional Series thus far.



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Contents

Contents Preface Acknowledgements Introduction

iii v xi

  1. Overview of Private Equity Introduction Definitions of Private Equity Private Equity Activities Major Types of Private Equity Private Equity Business Model Characteristics of a HPC Private Equity Controversy Brief History of the Development of the Industry Rationale for Investing in Private Equity What Attracts Private Equity Firms to Commit to Investments? Classes of Capital Used by Private Equity Firms Some Facts about Private Equity Fee Structure Some Other Benefits of Private Equity Disadvantages of Private Equity Private Equity as an Alternative Investment The Advantages of Private Equity over Senior Debt Private Equity versus Alternative Forms of Financing Comparison of Private Equity to Hedge Funds Largest Private Equity Firms Other Notable Private Equity Firms

1 2 4 5 5 6 8 9 10 10 12 12 14 14 15 15 16 16 18 18 20 21

  2. Types of Private Equity Investment Funds Introduction Primary Means of Private Equity Investment Different Types of Private Equity Investment Funds Risk Levels of Private Equity Investments Overview of How Private Equity Investments Work Phases of a Company’s Development The Investment Size Debate Size of the Investee Company Sector Specialisation Approach to Portfolio Construction Liquidity through a Secondary Market

23 24 24 25 26 27 28 29 30 30 31 33

vii

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Business Knowledge for IT in Private Equity

viii

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  3. Structure and Global Market Size Introduction Structure of the Private Equity Market Financing Stage and Industry Breakdown Size of the Global Private Equity Market

35 36 36 38 40

  4. The Business Environment Introduction Environmental Factors Affecting the Private Equity Industry Profiles of some Major Players Data Providers Indices

47 48 49 51 54 59

  5. Overview of Buyout Introduction Different Types of Buyout Transaction Roll-up Leveraged Buyout (LBO) A Look behind Two Large Buyout Deals Brief Explanation of a Dividend Recapitalisation and its Risks

61 62 62 66 68 71 74

  6. Venture Capital Introduction Definitions of Venture Capital Venture Capital Investing What is a Venture Capitalist? History of Venture Capital Venture Capital Firms and Funds Investment Focus Differences between VCs and Banks Venture Capital Funding Sectors within which Venture Operates List of Notable Firms

75 76 77 78 78 79 80 81 87 88 89 94

  7. Trends Introduction Rise of New Industry Players Popularity of Funds of Funds Introduction of Private Equity ETFs Popularity of Islamic Private Equity Fundamentals of Private Equity in the MENA Region Sovereign Wealth Funds and Private Equity Increasing Popularity of Private Equity Real-estate Funds Private Equity Investing in Emerging Markets Private Equity Investment in Clean Energy

95 96 96 97 99 101 102 104 105 108 110

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Contents

  8. The Investment Process 113 Introduction 114 Investment Process – Target Company’s Perspective 114 Investment Process – Investor in Private Equity Firm’s Perspective 122 Due Diligence 123 Monitoring 126 A Viewpoint on the Importance of Due Diligence 127   9. Common Systems Used in Private Equity Introduction IT Requirements of Private Equity Funds Profile of a System Software as a Service Used for Portfolio Management Improvement List of Systems

131 132 132 134

10. IT Projects Introduction Implementation of Data Warehouse Appliances The Advent of the Data Warehouse Appliance The Business is the Driver for Adoption Steps Involved in the Implementation Service-Oriented Architecture Adoption of Hardware-based Remote Management

139 140 140 141 142 143 145 150

11. Commonly Used Terminology Introduction List of Terminology

153 154 154

12. The Future The Future: What does it hold for the Private Equity Industry in Business and IT? Effects of the Credit Crunch on the Private Equity Industry The Growth of Private Equity in Africa Convergence of Private Equity and Hedge Funds Increased Investment in Clean Technology Increasing Role of Technology Conclusion

169



181 182 185

Appendix Bibliography Index

136 137

170 170 172 175 177 179 180

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Introduction

Introduction The content of this book will ensure that IT professionals who are working in private equity and those who aspire to work in the industry are equipped with business knowledge of this industry so that they can be on par with their business counterparts. The book opens with Chapter 1 that provides an overview of the private equity industry. Discussions included in this chapter include the private equity business model, facts about the private equity industry and a comparison between private equity funds and hedge funds. Chapter 2 is about the different funds types of funds managed by private equity companies and also includes a discussion of the approach to portfolio construction. Chapter 3 is about the structure and the global market size for private equity while Chapter 4 describes the business environment in which private equity companies operate. Chapter 5 discusses the concept of buyout in the private equity industry. Also included in this chapter are discussions on the theoretical underpinnings of leverage buyouts and the different types of buyout transactions. Chapter 6 provides an overview of venture capital and a list of notable venture capital firms and their respective speciality. Chapter 7 discusses some of the recent trends in the private equity industry. Chapter 8 discusses the investment process in private equity funds. Chapters 9 and 10 make up the IT-specific section of the book .Contained in Chapter 9 are a discussion of the IT requirements of private equity fund and a list of some if the systems used in the industry. Chapter 10 discusses the IT projects that can be executed at private equity firms including the implementation of data warehouse appliances. The last section of the book contains Chapters 11 and 12. Chapter 11 lists some of the common terminology used in private equity while Chapter 12 discuses the future of the industry. Please note the sets of data used in the book are not extrapolation or forecasting, they are used merely to provide a snapshot of the state of the private equity market.

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Overview of Private Equity This chapter introduces the concept of private equity and includes the history of private equity.

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Business Knowledge for IT in Private Equity

Introduction Hardly a day has passed in the global financial arena of late without new rumours of yet another company takeover target. This is what has led to the increasing popularity of private equity. Private equity is known as an asset class that invests in companies operating in a variety of sectors and at very different stages of their development. Private equity firms are essentially investment companies. The name ­private equity refers to the method they adopt for raising the funds they use. Instead of going to the stock market and selling shares, private equity companies raise funds from private sources, usually pension funds and wealthy individuals. They then use this cash, along with borrowed money, to buy companies that they have identified as underperforming, but with the potential to perform much better. Their main objective is to turn the business around and sell it on at a profit at a future date. Figure 1.1 Private Equity Buy-to-Sell Cycle

Privately held companies

Private equity fund

Another private equity fund

Yet another private equity fund

Public companies

Source: How is private equity changing public equity markets? By Tom Jenkins, Saïd Business School, Oxford University



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Private equity transactions are generally conducted by private partnerships that involve three main actors: 1) investors, 2) private equity firms, and 3) the companies they purchase, known as ‘portfolio companies’. Firms pursue different strategies covering the sizes of investment, the regions or countries in which they invest, specific industry sectors, or types of transaction such as start-up, expansion, buyout or recovery.

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Overview of Private Equity

While the term covers a broad spread of investment activities, since the underlying investments are always equities, returns are relatively correlated to the stock markets. The private equity industry works on the premise that deals are mostly turned round on a four-year time frame with the exit price about twice the entry cost after costs. For a directly invested fund, this would deliver on average about 20% p.a. return, before fees, as an internal rate of return (IRR). Figure 1.2 Typical Returns to Investors from Private Equity Limited Partner

Profit

Original investment*

$15.6 billion

$10 billion

General Partner Profit

$4.3 billion

Returns from $10 billion fund assuming return at 20% per year over a 6-year period * Including GP investment

The size of the private equity market has grown steadily since the 1970s. Private equity firms will, at times, pool funds together with a view to taking very large public companies private. There were a number of private equity purchases in excess of $30 billion during 2006 and 2007 alone. Many private equity firms conduct what are known as leveraged buyouts (LBOs), whereby large amounts of debt are issued in order to fund a large purchase. Private equity firms will then attempt to improve the financial results and prospects of the company in the hope of reselling the company to another firm or cashing out via an initial price offering (IPO). Private equity provides long-term, committed share capital to help unquoted companies grow and succeed. Private equity could assist businesses to start up, buy into another business, buy out a division of their parent company and turn around or revitalise another company. Obtaining private equity is very different from raising debt or a loan from a lender, such as a bank. Lenders have a legal right to interest on a loan and repayment of the capital, regardless of a company’s success or failure. Private equity is typically invested with a view to taking a stake in a company and the returns for investors, as shareholders, are reliant on the growth and profitability of this business. A typical private equity firm will raise a new fund every three to four years. Each fund becomes the private equity firm’s working capital for a new round

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Business Knowledge for IT in Private Equity

of investments in portfolio companies. The firms also work to identify, acquire, and manage all portfolio companies in which they invest their funds. As soon as a private equity firm has invested in a portfolio company, it typically assumes total control of the company. It may retain the company’s senior management staff or it may recruit managers of its own choosing from outside. In spite of retaining the portfolio company’s management, a member of the private equity firm usually takes a place on the board and the firm has the ultimate say in the way the company is run. After being in control of the company for a while, the private equity firm will sell its stake in the portfolio company on a stock market through an IPO, as stated above, to a larger company in the same industry or to another private equity firm. Private equity is usually categorised under the umbrella of ‘alternative investments’, complementary to the stocks and bond portfolios conventionally used by investors.

Definitions of Private Equity



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Equity capital is not quoted on a public exchange. Private equity consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity. Capital for private equity is raised from retail and institutional investors, and can be used to fund new technologies, expand working capital within an owned company, make acquisitions, or strengthen a balance sheet. (Investopedia) Private equity is medium- to long-term finance provided in return for an equity stake in potentially high-growth unquoted companies. Some commentators use the term ‘private equity’ to refer only to the buyout and buy-in investment sector. Others, in Europe but not the USA, use the term ‘venture capital’ to cover all stages, i.e. synonymous with ‘private equity’. (British Venture Capital Association) Private equity is a broad term that refers to any type of equity investment in an asset for which the equity is not freely tradable on a public stock ­market. Private equities are generally less liquid than publicly traded stocks and are thought of as a long-term investment. (International Financial Services ­London) The term ‘private equity’ includes a range of techniques used to finance commercial ventures in ways that do not involve the use of publicly tradable assets such as corporate stock or bonds. Private equity is the provision of equity capital by financial investors – over the medium or long term – to non-quoted companies with high growth potential (HPC). (European Venture Capital Association) Private equity investing entails investing predominantly in unlisted companies through a negotiated process and is typically a transformational, valueadded, active investment strategy.

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Overview of Private Equity

Private Equity Activities The following are some of the major activities of private equity: ■ Investment – This is the financing of businesses through venture capital, buyouts and other forms of financing. ■ Fund-raising – This refers to the money investors have committed to private equity funds in any one year. ■ Divestment – This is the realisation or exiting of a private equity ­investment. This is generally done by selling the company, writing off the investment or floating the company on a stock market. These activities are discussed in more detail in Chapter 2.

Major Types of Private Equity Private equity investments can be divided into the following categories: ■ Leveraged buyout, LBO or simply Buyout – This term is used to describe a strategy of making equity investments as part of a transaction in which a company, business unit or business assets are acquired from the current shareholders, usually with the use of financial leverage. Companies that generate operating cash flows are the types of firms that are involved in these transactions. ■ Venture capital – This is a broad subcategory of private equity that refers to equity investments made, typically in less mature companies, for the purpose of providing long-term, committed share capital to help unquoted companies grow and succeed.The sub-divisions of venture capital are often on the basis of the stage of development of the company, ranging from early stage capital used for the launch of start-up companies to late stage and growth capital that are often used to fund the expansion of existing business that are generating revenue but may not yet be profitable or generating cash flow to fund future growth. ■ Growth capital – This is a term used to describe equity investments, most often minority investments, in more mature companies that are seeking capital for expansion or for restructuring their operations, entering new markets or financing a major acquisition without a change of control of the business.



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Business Knowledge for IT in Private Equity

Other Strategies There are other strategies that can be considered to be private equity or a close adjacent market and they include: ■ Distressed or Special situations – These can be described as investments in the equity or debt securities of a distressed company, or a company where value can be unlocked as a result of a one-time opportunity (e.g. a change in government regulations or market dislocation). These categories can refer to a number of strategies, some of which straddle the definition of private equity. ■ Mezzanine capital – This refers to subordinated debt or preferred equity securities that are often indicative of the most junior portion of a company’s capital structure that is senior to the company’s common equity. ■ Secondary investments – These are investments made in existing private equity assets including private equity fund interests or portfolios of direct investments in privately held companies through the purchase of these investments from existing institutional investors. The structures of these types of investment are akin to a fund of funds. ■ Real estate – From a private equity standpoint, this will typically refer to the riskier end of the investment spectrum including ‘value added’ and opportunity funds whereby the investments usually more closely resemble leveraged buyouts than traditional real-estate investments. This is considered among certain investors to be a separate asset class. ■ Infrastructure – These are investments in various public works (e.g. bridges, tunnels, toll roads, airports, public transportation and other ­public works) that are carried out typically as part of a privatisation initiative on the part of a government entity. ■ Energy and Power – These are investments in a wide variety of ­companies (as opposed to assets) that produce and sell energy, including fuel extraction, manufacturing, refining and distribution (energy) or companies that produce or transmit electrical power (power).

Private Equity Business Model Different players are involved in the private equity business model and this model can be broken down into four main phases as shown in Figure 1.3:



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 Jason Corcoran. (4 February, 2008). ‘Investors scramble for infrastructure’. Financial News Online.  Tim Gray. (31 December, 2006). ‘Is It Time to Add a Parking Lot to Your Portfolio?’ New York Times.  MSN Money. 2008. Buyout Firms put Energy Infrastructure in Pipeline.  Adapted from European Venture Capital Special Report. ‘Guide on Private Equity and Venture Capital for Entrepreneurs’.

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Overview of Private Equity

Figure 1.3 Private Equity Business Model Institutional investors (banks, LP pension funds, (life) insurance companies, etc.) E

Fund of funds

Private individuals Family offices

E

E

Corporates (e.g. Intel, Sony)

Others

E

E

Private equity investment fund advises

GP

Private equity (Investment fund) management company

E Portfolio/Investee company 1 Portfolio/Investee company 2 Portfolio/Investee company 3 ...

Source: EVCA

■ Creation of a fund and underwriting by professional investors – Once the agreement of the controlling authorities have been obtained, private equity firms (also referred to as private equity management companies or general partners (GPs)) create investment funds that aggregate capital from investors (also referred to as limited partners or LPs). The private equity firms then use the capital to purchase high-potential companies (referred to as portfolio or investee companies).   Therefore, private equity fund managers interest individuals and institutional investors with specific expertise or considerable assets in subscribing for a fixed period to an investment fund, which will acquire equity stakes in high-potential companies according to a well-defined investment strategy. This could be according to the size of the target companies, their sector, and stage of development and/or geographical location. These investors are usually renowned sophisticated or professional investors who have a deep understanding of the risks associated with this type of operation.   Given that investment funds are for the most part closed, institutional investors are not able to leave these funds before their term (or they will have difficulty in doing so). Entrepreneurs perceive financial stability as one of the obvious advantages when they seek private equity investment.   In exchange for the money they contribute, investors are given a prenegotiated stake in the equity of the investment fund and they become fully fledged shareholders that share in the risks borne by the private equity firm.

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Business Knowledge for IT in Private Equity

  The investors’ objective, through the fund, is to create value in the portfolio company in order realise a capital gain – shared with the owners – on exit as opposed to taking control of the company. In the private equity industry, such financing is often referred to as ‘patient capital’ as the aim is to profit from long-term capital gains as opposed to short-term regular paybacks. ■ Investing the fund – As soon as the target amount of capital has been raised, the subscription is closed. The private equity investment managers search for high-growth companies to invest in, following the investment strategy they presented to the institutional investors.   There are occasions whereby private equity investment funds will ‘club’ together to form a financial syndicate to make an investment. This will occur if the risks are high or if the amount of capital required in the operation is particularly substantial. One of the investment funds will be the group’s representative in the dealings the syndicate has with the entrepreneur. This representative will follow a mandate negotiated with its partners. ■ Managing the investment – The running of the investment operations by the fund managers involves preparing the exit strategies depending on market conditions, agreements prepared in advance with the entrepreneurs and opportunities for disposal.   Given the interest of the fund managers on behalf of investors in creating value in the company, they will follow their investment over the long term and will participate in any subsequent rounds of financing that are needed. ■ Redistribution – On exit from the investment, the fund managers redistribute the capital to the original investors on a pro-rata basis according to some of the initial investment. These reimbursements, together with the capital gains, give the institutional investors the financial wherewithal to honour their insurance contracts, pensions or savings deposits.   Institutional investors desire considerable profit from their investment to compensate for the fact that their capital is tied for a long period of time and to ensure that they can reimburse the money allocated to them by their clients.   The fund manager may decide to launch a second fund if they have invested the capital collected from the investors and exited certain investments. The historical performance of fund managers boosts their credibility to attract new investors and is important, given the stiff competition with other managers in the asset management space.

Characteristics of a HPC 

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■ High-quality management – High potential companies usually have a high-quality management team that can transform an average or even weak company into a big success and this is the major criterion for private

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Overview of Private Equity

equity investors at all stages of development. Key features are previous industry experience and previous entrepreneurial experience, preferably in a company also financed by private equity and in the same stage of development. ■ Significant market potential – This is considered to be the second most important characteristic of a HPC. For early stage and companies in expansion, this translates into a predefined market size, depending on the jurisdiction, and double-digit growth potential. In the early stage, growth and development projections are evaluated by private equity firms with prospective customers before investments are made in order to verify their feasibility.   In the expansion stage, a HPC typically possesses competitive advantage and operates in a fast-growing market or is planning to enter into a new market. ■ Internal processes that can be evaluated – The processes at work inside a business that can be evaluated are other distinguishing characteristics of a HPC. From a private equity investment standpoint, it is an essential feature that investors can use to form an opinion on whether to enter a deal or not.   In the early stage, where a company’s cash flow is usually negative, internal processes are of less importance and help can be sourced from professional services firms outside the company.   In the expansion stage, HPCs typically have good strategic and financial planning as well as the right tools and information systems in place to enable management and investors to access relevant data in a timely manner.

Private Equity Controversy Ardent supporters of private equity hail its ability to create jobs quickly and its contribution to the global economy. The private equity industry claims it is improving the performance of companies all over the world by giving them stronger management and market discipline. However, there are others that disagree with this claim; most notably employees at companies which have been bought by private equity groups only to witness a large number of job cuts being made. Critics describe such an action as ‘asset stripping’, saying that the private equity funds have to make radical cuts as a result of the excess debt they take on to finance their deals.

 This is the stage at which a business has reached or is approaching breakeven point.  Asset stripping is buying a company, and then selling off businesses it owns separately.

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Business Knowledge for IT in Private Equity

However, the private equity firms, in response, say that they simply have to cut jobs to make the companies they buy profitable. The transparency of private equity firms is another concern, with critics saying a lack of accountability means that decisions are made behind closed doors.

Brief History of the Development of the Industry The term ‘private equity ‘only became prevalent in the late 1980s after public interest in leveraged buyout fund activity, especially in the USA. In reality, the private equity market dates back to the creation of groups in Europe such as the UK firms Charterhouse Development Capital in 1934 and 3i in 1945, and in the USA such as the American Research and Development Corporation in 1946. The private equity market stayed patchy for a while, made up mainly of venture investments in early stage companies by private individuals (referred to as business angels) and, to a lesser extent, foundations and university and government investment programmes. Some of the more notable early ­venture-backed companies in the USA include Federal Express (FedEx), Apple Computers and Digital Equipment.

Rationale for Investing in Private Equity The fundamental rationale for investing in private equity is to enhance the risk and reward characteristics of an investment portfolio. Investing in private equity allows the investor to generate higher absolute returns and at the same time improve portfolio diversification. In addition, the long-term returns of private equity can outperform quoted equities. This has been the case in the USA for over 25 years and in Europe for over 15 years. For many institutions, the potential to outperform more ­traditional asset classes is a justification for the different risk profile of the asset class:

10

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■ True stock picking in a low-inflation, low-growth environment – A low inflation environment creates an emphasis on growth stocks and a way to achieve outperformance. One of the main skills of successful private equity managers is the ability to select companies with growth potential and actively create the conditions for growth in those companies. Given that private equity funds have a large, often controlling, stakeholding in companies, few, if any, other private equity managers will have access to the same companies. Thus, private equity managers are true stock ­pickers.

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Overview of Private Equity

■ Absolute returns – Too much volatility and meagre investment performance experienced by quoted equity portfolios, some of which have index-tracking strategies or are benchmarked to an index, have resulted in a swing in favour of strategies that seek absolute returns.   Private equity managers search for absolute returns, and the conventional structure used to incentivise them, carried interest, is highly geared towards making net cash returns to investors possible. ■ Portfolio diversification improves risk and volatility characteristics – Diversification can be further improved in a balanced portfolio through the introduction of private equity.   If private equity is added to a balanced portfolio, volatility can be reduced, which contributes to an overall improvement in the risk profile. The reason for this is the lower correlation between private equity and quoted securities markets. As a result, higher targeted returns for the same level of calculated risk or a reduction in the level of risk in the port­ folio while preserving the target rate of return will be achieved. ■ Imbalance between public and private markets – Although the majority of the GDP of many countries around the world is generated by private companies, the private equity market has far fewer funds under management than the quoted markets. Industry experts, however, believe that there is still capacity for growth in this asset class and a much greater range of assets from which to select. This is especially true in some countries where private equity is still a smaller fraction of the GDP than in the USA or UK. ■ Exposure to the smaller companies market – The private equity industry has introduced corporate governance and offers an attractive way of obtaining exposure to a growth sector. ■ Access to legitimate insider information – Private equity man­ agers have access to a greater depth of information on proposed company investments. This allows managers to assess more accurately the viability of a proposed business plan and to project the post-investment strategy to be adopted and anticipate future performance. ■ Ability to support entrepreneurs – The global popularity of entrepreneurism as an essential cog in the world economy has prompted rapid growth in technological innovation and considerable benefits for the economy in recent times. The private equity asset class is a vehicle for gaining investment exposure to the most entrepreneurial sectors of the global economy.

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Business Knowledge for IT in Private Equity

What Attracts Private Equity Firms to Commit to Investments? A lot of smaller companies are ‘life-style’ businesses that proprietors set up with the main aim of providing themselves with a good standard of living and job satisfaction. These businesses are not generally suited for private equity investment, given that they are unlikely to provide the potential financial returns to attract the attention of an external investor. Businesses that can be described as ‘entrepreneurial’ are different from others in their aspirations and potential for growth, rather than their current size. These types of businesses seek to grow rapidly to a considerable size. In practice, unless a business can offer the prospect of significant turnover growth within a five-year period, the likelihood of it being of interest to a ­private equity firm is remote. Private equity investors are only interested in companies with high growth prospects and a management team of experienced and ambitious individuals who are adept at turning their business plan into reality. However, as long as there is real growth potential, the private equity industry is interested in all stages, from start-up to buyout. In general, private equity firms look for the following: ■ Businesses that are growing fast and offer competitive products and ­services; ■ A business’s capacity to generate recurring profits and a loan capacity, in the case of disposal or transfer; ■ Companies with a quality and stable management team who are able to turn the negotiated goals into reality; ■ Businesses with solid management procedures that are already in place or could be put in place as quickly as possible; ■ Companies with a transparent legal structure where there is a clear delineation between personal and professional assets.

Classes of Capital Used by Private Equity Firms The main classes of share and loan capital used to finance companies (UK limited liability companies are used as the basis) are shown below.

Share Capital

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The structure of share capital that will be developed entails the establishment of certain rights. Through these rights, the private equity firm will attempt to balance the risks it is taking with the rewards it is looking to earn. It will also be aiming to put together a package that best suits the target company for future growth.

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Overview of Private Equity

Ordinary Shares These are equity shares that are entitled to all income and capital after the rights of all other classes of capital and creditors have been satisfied. Ordinary shareholders have voting rights. In a private equity deal, these are the shares typically held by the management and family shareholders rather than the private equity firm.

Preferred Ordinary Shares These may also be referred to as ‘A’ ordinary shares, cumulative convertible participating preferred ordinary shares or cumulative preferred ordinary shares. They are equity shares with preferred rights. They usually rank ahead of the ordinary shares for both income and capital. As soon as the preferred ordinary share capital has been repaid and then the ordinary share capital has been repaid, the two classes would then rank pari passu in sharing any surplus capital. Their income rights may be defined: they may be entitled to a fixed dividend (a percentage linked to the subscription price, e.g. 8% fixed) and/or they may have a right to a defined share of the company’s profits – known as a participating dividend (e.g. 5% of profits before tax). Preferred ordinary shares have votes.

Preference Shares These are non-equity shares. They rank ahead of all classes of ordinary shares for both income and capital. Their income rights are defined and they are ­usually entitled to a fixed dividend (e.g. 10% fixed). The shares may be redeemable on fixed dates or they may be irredeemable. In some cases, they may be redeemable at a fixed premium (e.g. at 120% of cost). They may be convertible into a class of ordinary shares.

Loan Capital Loan capital ranks ahead of share capital for both income and capital. Loans typically are entitled to interest and are typically, though not necessarily, repayable. Loans may be secured on the company’s assets or may be unsecured. A secured loan will rank ahead of unsecured loans and certain other creditors of the company. A loan may be convertible into equity shares. Alternatively, it may have a warrant attached that gives the loan holder the option to subscribe for new equity shares on terms fixed in the warrant. They typically carry a higher rate of interest than bank term loans and rank behind the bank for payment of interest and repayment of capital.

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Business Knowledge for IT in Private Equity

Some Facts about Private Equity The following are some facts about private equity: ■ The biggest 5 private equity deals together are larger than the annual budgets of all but 16 of the world’s largest nations. The 5 biggest deals involved more money than the annual budgets of Russia and India. ■ The annual revenue of the largest private equity firms and their portfolio companies would give private equity 4 of the top 25 spots in the Fortune 500. One firm, Kohlberg Kravis Roberts & Co., would crack the top 10. These private equity firms have more annual revenue than companies such as Bank of America, JP Morgan Chase, and Berkshire Hathaway. ■ The top 20 private equity firms alone control companies that employ nearly 4 million workers. ■ There were a record $197 billion worth of private equity mergers in the first quarter of 2007 alone. ■ Industry experts believe that a $100 billion private equity buyout trans­ action could happen in the near future – putting huge companies such as Dell, Boeing and Apple Computers within the range of the private equity buyout industry.

Fee Structure While exact figures are difficult to obtain, the hallmark of the private equity industry is the unbelievable sums of money being generated for a small number of individuals who are in control of the private equity industry. The main principals of the largest private equity firms are billionaires. The money they obtain from investors is used to continually launch corporate buyouts worth large sums of money in the region of tens of billions of dollars or any currency in their given region in which they operate, charging fees of hundreds of dollars to the companies they purchase and generating profits of 20% or more. Private equity is viewed as a financial juggernaut that generates hefty returns for investors and astonishing wealth for the top executives of the ­private equity firms. Private equity investment is different to a typical investment in shares of a publicly traded company that may pay out periodic dividends or that can be sold on at any given time. Investors in private equity profit from their investment when the firm sells, or, in private equity terms, ‘exits’ the portfolio ­companies that constitute the fund. These types of exit can include partial sales, complete sales, or ‘recapitalisations’. A recapitalisation entails the

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 Service Employees International Union. (2008). ‘An Introduction to Private Equity’. Available from www.behindthebuyouts.org/introduction.

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Overview of Private Equity

­ rivate equity firm paying itself a special dividend, usually funded by having a p portfolio company borrow more money. The limited partners in a given private equity fund usually together get paid about 80% of the profits from the deal. The remaining 20% is retained by the private equity firm as its fee for making a profit for the investors. The profit is usually known as ‘the carry’ or ‘carried interest’ plus a 1.5 to 2% annual management fee. A number of private equity firms also charge a management fee to the portfolio companies in which they invest and in some cases, this can be shared with investors. Transaction fees are also charged by some firms as a percentage of the value of any acquisition or sale of a portfolio company.

Some Other Benefits of Private Equity There is ample evidence that companies backed by private equity grow faster than other types of companies. This is achievable through the provision of a combination of capital and experienced personal input from private equity executives, which differentiates it from other forms of finance. Private equity can help a company realise its ambitions and offer a stable base for decision making in a strategic manner. In addition, it can strengthen leadership, ­refocus strategy, reduce cost structures, institute growth initiatives, or even break up the company to sell it in parts. When it works as planned, it results in more efficient use of capital, which in turn stimulates the economy and drives ­innovation. The private equity firms look to increase a company’s value to its owners and choose to eschew taking control of day-to-day management. Even though the company may have a smaller proverbial ‘slice of the cake’, within a few years the company’s ‘slice’ should be worth significantly more than the ‘whole cake’ was to the company before. Private equity firms often collaborate with other finance providers and may be capable of assisting a company with creating a total funding package for their business.

Disadvantages of Private Equity ■ There could be conflicts of interest, because private equity partners involved in the running of companies may have different priorities from other investors in the private equity fund. ■ There are shorter investment horizons, because the intention is usually to sell the company after a few years rather than focusing on long-term growth. ■ There is often a lack of transparency, making companies less accountable to the public and their workforces. ■ Greater leverage may make companies more vulnerable to economic downturns and has the potential to pose risks to lenders and the financial system.

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■ There are risks of job destruction through the bid to extract value. ■ There is a risk to pensions through selling assets and loading companies with debt.

Private Equity as an Alternative Investment Since the 1980s, private equity has become generally accepted as an asset class. Investment in private equity is a major contributor to portfolio diversification. While there is some correlation between returns on private equity and public equity and bond markets, the correlation is not high. A number of institutions view the potentially higher returns of private equity investments over conventional asset classes as justification for the higher risk of such investments. Private equity investments are relatively illiquid, especially in the early years. The life cycle of an average private equity fund investment is, on average, three to seven years. Investors in private securities normally exit their investment and achieve returns through an initial public offering (IPO), a sale (to corporate buyers or another private equity firm), a merger or a recapitalisation. Given that the companies are not listed on a public exchange, investors that are looking to exit their private equity holding are able to do so through the sale of the holding to another investor through the secondary market. A major reason for the high growth of the private equity market since the 1980s has been the fact that private equity investments have generated consistently higher returns than most public equity markets and bond markets.

The Advantages of Private Equity over Senior Debt

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A provider of debt (usually a bank) gets rewarded through interest and capital repayment of the loan and business assets used as collateral for the loan. In the event of a default on the repayment of the loan, the lender can put the business into receivership, which may lead to the liquidation of any assets as a last resort. Debt which is secured in this way, and which has a higher priority for repayment than that of general unsecured creditors, is known as ‘senior debt’. However, private equity is not secured on any assets, although part of the non-equity funding package provided by the private equity firm may demand some form of security. The private equity firm, therefore, often faces the risk of failure in a similar way to other shareholders. The private equity firm is an equity business partner and earns its rewards through the company’s success, generally achieving its principal return by realising a capital gain through an ‘exit’, which may include:

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Overview of Private Equity

■ The sale of the shares back to the management; ■ The sale of the shares to another investor (such as another private equity firm); ■ A trade sale, i.e. the sale of company shares to another; ■ A stock market listing of the company. In general, private equity is provided as part of a financing package, but to simplify comparison it will be prudent to compare private equity with senior debt. Private Equity

Senior Debt

Medium to long term.

Short to long term.

Committed until ‘exit’.

Not likely to be committed if the safety of the loan is threatened. Overdrafts are payable on demand; loan facilities can be payable on demand if the covenants are not met.

Provides a solid, flexible, capital base to meet future growth and development plans.

Useful source of finance if the debt to equity ratio is conservatively balanced and the company has good cash flow.

Good for cash flow, as capital repayment, Requires regular good cash flow dividend and interest costs (if relevant) to service interest and capital are tailored to the company’s needs and to repayments. what it can afford. The returns to the private equity investor depend on the business’s growth and success. The more successful the company is, the better the returns all investors will receive.

Depends on the company continuing to service its interest costs and to maintain the value of the assets on which the debt is secured.

If the business fails, private equity investors will rank alongside other shareholders, after the banks and other lenders, and stand to lose their investment.

If the business fails, the lender generally has first call on the company’s assets.

If the business runs into difficulties, the If the business appears likely to private equity firm will work hard to fail, the lender could put your ensure that the company is turned around. business into receivership in order to safeguard its loan, and could make you personally bankrupt if personal guarantees have been given. A true business partner, sharing in risks and rewards, with practical advice and expertise (as required) to assist business success. Source: BVCA

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Assistance available varies considerably.

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Private Equity versus Alternative Forms of Financing There are also alternative forms of financing for businesses, apart from private equity: self-financing or capital raising through stock market floatation: ■ Private equity versus self-financing – Proprietors of businesses ­usually go down the route of self-financing either on their own or with friends, family, or business angels in order to access funds in a relatively quick way, but it is not usually a viable long-term solution for a business that is growing. It is often the case that personal relations can be enmeshed with the business and the joint shareholders seldom play a valuable role in supporting the proprietor or the business. ■ Private equity versus capital raising through a stock market floatation – As private equity investment is a medium- to long-term investment that does not offer the same liquidity as a stock market floatation and one that ties the investor closely to the company, the investment is more secure because it is less susceptible to external economic fluctuations. Given their closed structure, private equity funds prevent fund managers from premature exits and this also strengthens the long-term commitment of the fund to the companies in which they invest.   On the other hand, companies that seek floatation on the stock market need to have attained a certain level of activity, as well as regular public reporting and control by stock market regulators.

Comparison of Private Equity to Hedge Funds Private equity firms are often described as the debutante sisters of hedge funds and are similar to hedge funds in many ways. Both are lightly regulated, private pools of capital that invest in securities and compensate their managers with a share of the fund’s profits. While private equity funds invest primarily in very illiquid assets such as early-stage companies and investors are ‘locked in’ for the entire term of the fund, most hedge funds invest in relatively liquid assets and allow investors to enter or leave the fund, in certain cases requiring some months’ notice. Hedge funds often invest in private equity companies’ acquisition funds. Highlighted below are other major differences between the two types of funds:

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 An angel investor or angel (known as a business angel or informal investor in Europe) is an affluent individual who provides capital for a business start-up, usually in exchange for convertible debt or ownership equity.

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Overview of Private Equity

■ Time to hold – Hedge funds’ investment activities, whether investing in debt or equity, characteristically demand a quicker exit strategy than private equity funds. Hedge funds normally prefer a quick turnaround of their investments, often in as few as 6 months and most likely in no more than 18 months. Yet the nature of some hedge fund investments is such that they buy debt at a deep discount with a view to converting that debt to equity, then monetising that equity (through a recapitalisation, refinancing, sale, merger or other disposition) in a short time period. This is known in the industry as ‘loan to own’ and is a function of, among other things, the liquidity and leverage differences between the two types of funds.   As stated as earlier, investments by private equity firms often are held for five to seven years, or even longer. The time-hold differences directly impact on the exit strategy, risk tolerance and desired rate of return of the two types of funds. ■ Strategic direction – Given the longer hold periods they prefer, private equity funds have a deep interest in the strategic direction of the companies and industries in which they invest. Therefore, before making an investment, private equity firms carry out a considerable amount of research regarding both the targeted company and the industry in which it operates. As soon as an investment is made, private equity firms dedicate a considerable amount of ‘hands-on’ time to further formulate strategies, carry out an assessment and evaluation of the results, and make changes accordingly. This generally translates into active participation on the board of directors. Hedge funds carry out assessments of target companies’ strategies with a dissimilar focus, one that is tied to hold periods, returns and company and industry hedging strategies. Nevertheless, hedge funds are increasingly obtaining seats on boards of directors and seeking to influence management decisions made by companies in which they have invested. ■ Industry focus – Certain investors value volatility while others tend to avoid it. Hedge funds, however, perceive volatility as an advantage and a catalyst to achieve higher rates of return, especially since they have the ability to hedge their investments through company or industry counter ‘bets’. Shrewd management, a competitive industry and a volatile marketplace can boost high returns and profits. Hedge funds, in general, focus on underperforming companies given that such companies are more volatile, creating a corresponding potential for higher returns. ■ Due diligence methodology – A major difference also lies in the degree of due diligence performed. Even though both investors have well-developed methodologies for performing due diligence, hedge funds usually perform due diligence hastily, given that their exit strategy may be very different. Due diligence performed by private equity funds normally takes longer and may be more detailed. A high level of financial sophistication exists with both types of funds; consequently, each takes a customised approach to due diligence.

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■ Liquidity and leverage – The different use of leverage and liquidity demands for the types of funds are drivers for different hold periods. In a nutshell, hedge fund investors by and large are able to withdraw their investments more frequently than private equity fund investors. In the case of hedge funds, volatile withdrawal demands force a focus on shortterm returns and may lead to shorter hold periods. ■ Control – Private equity firms may replace the company’s senior manage­ ment when they buy the equity of a target company. However, they often experience more difficulty in finding top-quality management than in ­ finding the right investment. In the event that senior management is retained, the private equity fund will control the board of directors. Therefore, the equity sponsor has a direct influence on the strategic direction of the company.   Newly appointed directors are often principals of the private equity firm. But for many hedge fund investments, the current management structure may often remain untouched while the hedge fund works toward a buyand-sell trading position in debt or equity. The trading position is often protected through mysterious and complicated hedging strategies. However, in a ‘loan to own’ investment, the hedge fund may imitate the private equity fund in the areas of both management and board involvement. ■ Mark to market – The hedge fund often marks its investment to market and utilises this valuation methodology in its decision making with respect to exit strategies. Private equity funds have a tendency to use long-term valuation methodologies when valuing their investments. ■ Management fees – Management fees, like engaging in mark-to-­market valuation, can result in additional profit-taking pressures. As for private equity investment, the management fee is usually end-loaded and, consequently, highlights the long-term result of holding the investment. The hedge fund calculates its management fee in a much shorter time frame and, coupled with the mark-to-market pricing pressure, this furthers the hard-line nature of the hedge fund investment methodology.

Largest Private Equity Firms Figure 1.4 shows some of the largest private equity firms in the world on the basis of capital they have raised for direct private equity investment.

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Overview of Private Equity

Figure 1.4 Largest Private Equity Firms Firms ranked by amount of capital raised for direct private equity investment between 2002 and 2007

$bn

The Carlyle Group Goldman Sachs Princ. Investm. Area TPG Kohlebeg Kravis Roberts CVC Capital partners Apollo Management Bain Capital Permira Apax Partners The Blackstone Group

52.0 49.1 48.8 40.0 36.9 32.8 31.7 25.4 25.2 23.3

Washington DC New York Fort Worth New York London New York Boston London London New York

Source: Private Equity International

Other Notable Private Equity Firms Name Headquarters 3i Group Hellman & Friedman Teachers’ Private Capital EQT Partners Candover BC Partners Onex Bridgepoint Pacific Equity Partners Nordic Capital

Capital Raised 2002–2007 ($ billions)

London 13.37 San Francisco 12.00 Toronto 10.78 Stockholm 10.28 London   8.29 London   7.90 Toronto   7.90 London   6.05 Sydney   4.74 Stockholm   4.54

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Types of Private Equity Investment Funds The different types of products offered by private equity companies are discussed in this chapter. Also included is a discussion on the different stages of a company’s development.

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Introduction Institutional investors worldwide consider private equity an increasingly essential component of their overall asset allocation. Organisations from pension plan sponsors to endowments, foundations and family offices have traditionally participated in private equity investing for a variety of reasons, the most important of which include: ■ A diversified portfolio of private equity can generate highly attractive returns when compared to a portfolio of traditional marketable securities. ■ Private equity provides a source of diversification that can reduce overall portfolio risk; private equity focuses on long-term investments that are relatively insulated from short-term valuation fluctuations associated with the public securities markets. ■ Investors can become participants in a vibrant market of privately held companies, certain types of which are not generally found in public securities markets. That said, in the next section the different types of private equity investment funds will be discussed.

Primary Means of Private Equity Investment The primary means of private equity investment are: ■ Investment in private equity funds; ■ Outsourcing selection of private equity funds, for example through a fund of funds (see Chapter 6); and ■ Co-investment and direct investment in unlisted companies. Figure 2.1 is diagrammatic representation of the primary means of private equity investment. Although it is occasionally the ultimate aim of investors to be capable of making co-investments and direct investments in companies, compared to investing via funds it requires more capital (to achieve comparable diversification and exposure), a different skill set, more resources and different evaluation techniques. This can be mitigated by co-investment with a fund and the rewards can be high, but there is higher risk and the potential for complete loss of invested capital. Industry experts recommend that only experienced private equity investors should adopt this strategy.

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Types of Private Equity Investment Funds

Figure 2.1 Primary Means of Private Equity Investment Company Investing in PE funds Fund of funds

PE fund

Company

PE fund

Company

PE fund Co-investments Direct investments

Company Company

Source: Australian Venture Capital Association

Different Types of Private Equity Investment Funds Private equity funds differ in their areas of specialisation, their shareholders and their management structures. The source of a private equity fund can impact on the structure of the deal offered, can influence the decision of a fund manager making quick decisions or otherwise, and even have an impact on the continuity of the people the entrepreneur has dealings with and their management style as soon as the capital is invested. Figure 2.2 shows another diagrammatic illustration of the different ways to invest in private equity: ■ Independent – These are private equity funds in which third parties are the main providers of capital and in which no shareholder holds a majority stake. This is the most common type of private equity fund. ■ Captive – These are funds in which a single shareholder provides most of the capital, i.e. where the parent organisation allocates money to the fund from its own internal resources. These are usually subsidiaries of or departments in a bank, financial institution, insurance company or industrial company. These also include the so-called corporate or industrial funds launched by companies that seek to invest in sectors relevant to their core activities and to identify new technologies. Banks that want to separate their role as a commercial banker from their role as an investor also create these types of funds. ■ Semi-captive – These are funds in which the shareholder provides a large portion of the capital, but a large share of the capital is raised from third parties. A semi-captive fund can also be a subsidiary of a financial

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Figure 2.2 Different Ways to Invest in Private Equity Funds Institutional investors

Fund of funds

Fund

Fund

Securitisation notes, structured products

Fund

Portfolio companies Source: Grabenwater, Ulrich and Weidig, Tom. (2005). ‘Exposed to the J-Curve: Understanding and Managing Private Equity Fund Investments’. Euromoney Institutional Investor PLC

institution, an insurance company or an industrial company that is run as an independent company. ■ Fund of funds – This is a pooled fund vehicle whose manager assesses, selects and allocates capital among a number of private equity funds. Given that a number of funds of funds have existing relationships with foremost fund managers, and given that commitments are made on behalf of a pool of investors, this can be an effective method for some investors to have access to funds with a higher minimum commitment or to heavily subscribed funds.

Risk Levels of Private Equity Investments

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Investors often view private equity as a risky asset class. This is especially true for direct investments in companies. In the venture capital segment particularly, it is evident that the total loss rate of private equity direct investments is very high. Then again, successful venture capital investments return many times the invested amount. However, investments in private equity funds are far less risky than one direct investment. Institutional investors always invest in several private equity funds to gain exposure to a range of portfolio companies where the gains on a few would more than compensate the losses on others. Other investors do not have the skills or resources to directly invest in a sufficient number of funds, and choose funds of funds or other alternative vehicles.

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Types of Private Equity Investment Funds

Overview of How Private Equity Investments Work There is no single legal structure associated with private equity investment funds; there are variations from country to country. However, there are two main types of funds: funds with a limited lifespan, usually about 10 years, and funds with an unlimited lifespan. The former is most widely adopted, based around a partnership agreement between the institutional investors and the investment fund management team. In Europe, for instance, legal structures used include SICAR in Luxembourg, Fondo Chuiso in Italy and FCPR (Fonds Communs de Placement à Risques) in France. The fund managers (GPs) have unlimited liability for the investment whilst the institutional investors (LPs) are liable for the amount of capital they have provided and are not actively involved in the management of the investments. The management team draws down the funds in blocks of cash as and when the capital for their investments is required. In order to cover operating costs, an allowance for fees of around 1.5% to 2% of the capital raised is deducted in advance from the investors’ commitments in accordance with a management contract that is drawn up. The fund managers have an entrepreneurial mindset throughout the lifespan of the fund and check that their management company is operating in a balanced manner. As the fund divests (i.e. exits from the investment), the amount recovered is usually not reinvested but redistributed to the provider of the capital. The institutional investors are paid the first portion of the profit and an agreed target rate of return or ‘hurdle rate’10 as a reward for tying up their capital over the lifespan of the investment. In some cases, there is additional profit above the hurdle rate, which is shared between the fund managers and other investors. While the fund managers are at liberty to pay themselves 20% of this capital gain, the LPs will be paid the remaining 80%. ‘Carried interest’ or ‘carry’ is the term used to describe this 20% of the profit above the hurdle rate. After a certain number of years, depending on the structure of the fund, it is mandatory that all the investment in the portfolio is divested and the investment fund closed. The overall performance of the fund and its management team is evaluated through calculation of the internal rate of return (IRR), the net difference between the capital invested and the money paid back to investors. The rate depends on the length of time for which each block is tied up and the amount returned.

10 The hurdle rate is the rate of return that must be attained before a manager can be paid a carried interest payment from a fund.

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As for funds with unlimited lifespan, they do not operate with the same time limitations as the funds described above. Nevertheless, the managers also collaborate in a management company and manage their investments under the same conditions. In recent times, these managers have been remun­ erated on a par with their counterparts discussed above. The capital gains they accrue are reinvested in the fund.

Fund Specialisation Industry reports show that fewer and fewer funds are simply generalist, with no sector or business type specialisation, and the majority of private equity funds have opted for specialisation in certain industrial sectors or services, or in companies at a given stage of development, of a specific size or with a particular geographical coverage (regional, national or international).

Phases of a Company’s Development There are broad variations in funds, depending on the different phases in a company’s life cycle, which can be defined along the following lines, bearing in mind that the boundaries between the different phases can be blurred:

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■ Seed – This type of financing is designed to research, assess and develop an idea or initial concept before a company has attained the start-up phase. At this stage, business angels (often former directors or entrepreneurs) are the main investors. They join a project to help get it off the ground and provide some of their personal funds. ■ Start-up – Start-up financing is utilised for product development and the initial marketing effort. Businesses may still be in the creation phase or have just started operating and have not made any commercial sale of their products.   A number of venture capital professionals will join the proprietor of the business and help them with the setting up of the business when the product has taken shape and formed the starting point of a real ‘business plan’.   Capital is usually required for research and development of the product as well as to train personnel at this stage. This is particularly the case for technology sectors such as electronics, biotechnology and IT.   There is a high risk of failure for these companies and this requires stringency in the choice of projects on the part of investors. ■ Post-creation – At post-creation stage, product development has been completed and the business requires capital to start producing and selling the product. Profits have not been generated at this stage. ■ Expansion/development – The expansion stage is when the business attains or is approaching breakeven. As this is the period of high growth,

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Types of Private Equity Investment Funds

capital is utilised to boost production capacity and sales power for new product development, to finance acquisitions and/or for increasing the working capital of the business.   A number of rounds of financing are required to get through this period and the business has to make sure there is balanced growth. Consummate investors usually like to see a significant amount already invested in a ­company and if the company already has a track record of development and is already operating with a robust structure in place, it adds to the allure.   Also included in this stage are bridge financing11 and rescue or turn­ around investments.12 ■ Transfer/succession – Total or partial retirement of the head of a company provides a chance to implement a leveraged operation (capital provided in the form of debt and equity) to embark on a buyout or buy-in. These can also occur when a large company sells off a business unit, or in the event of a repurchase of shares held by family members or in the case of the eventual investors from previous stages of development exiting the business. The prevalent management team (in the case of a buyout ) or a new team (in the case of a buy-in), with the backing of financial investors, creates and provides finance for a holding company that then uses debt to purchase the target company. The dividends declared by the target company then allow the holding company to pay back its debt. The structure of this operation implies that it is only relevant to a reputable company or business unit that has a positive and/or predictable cash flow. Buyouts (or buy-ins) enable a company to continue trading, make generational change at the top of the company possible, allow restructuring to be achieved more efficiently by fresh cash injection and provide job protection whilst protecting employees’ shareholdings. Private equity investors contribute far more than just finance as they support the company management by offering their knowledge of the industrial sector and long-term commitment as well as a network of contacts that may be invaluable to the business. The sums of money invested are usually sizeable and the larger investment funds have traditionally specialised in these operations.

The Investment Size Debate This debate is centred on majority versus minority investments. Private equity investors regularly acquire a considerable share in start-ups or very young 11 Temporary funding that will eventually be replaced by permanent capital from equity investors or debt lenders.

12 This type of financing is made available to existing companies that have experienced trading difficulties in order to re-establish prosperity.

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companies, given that these companies may experience difficulty in raising capital from conventional sources (such as banks) and as a result of their heavy involvement in the setting up of the operation. These start-ups or very young companies require a great deal of assistance, given that the head of the company needs to divide their time between product development and more general management. In this case, the support of private equity investors is very essential. But the amounts of money invested are less than in the development or ensuing stages. During buyouts, private equity investors are also usually holders of majority stakes in the companies. But they can hold minority stakes during the development stage if the company is already up and running and is seeking capital for completion of its development. However, in spite of the size of the initial stake, agreements often make allowances for equity to be returned to the investee company or entrepren­ eurs when they have achieved specific objectives. This allows the private equity investor to move from being a majority stakeholder to a minority stakeholder.

Size of the Investee Company The commonly held belief is that private equity is not very active in small and medium-sized companies. However, recent statistics have proved otherwise. For instance, in Europe in 2006, 89% of the private equity-backed companies had less than 100 employees. The largest operations (in companies with over 1,000 employees) represented less than 9% of the total number of investments in 2006 but accounted for 49% of the total European capital invested.13 Over a period of five years from 2002 through to 2006, over E90 ­billion were invested in companies with more than 1,000 employees, across 1,854 operations. While this represents 42.9% of the total European amount invested in that period (E212 billion), it accounts for only 3.5% of the total number of investments (52,515).14

Sector Specialisation Sector specialisation lets investors make better evaluations of a business. The proprietor of the business is able to deal with a specialist in their sector with whom they can share their strategic thoughts. For example, in 2006, the sectors that attracted the highest interest from private equity in Europe (in terms

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13 Source: EVCA Yearbook 2007. ‘Annual Survey of Pan-European Private Equity and Venture Capital Activity’. 14 Sources: EVCA Yearbooks 2003–2007.

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of the amount invested) were consumer-related and non-industrial or financial services, together accounting for over 30% of investment, followed by communications, healthcare (including medical) and computer-related. The largest number of investments was made in computer-related, healthcare and consumer-related companies.15

Approach to Portfolio Construction Portfolio construction will be indicative of the main objectives of investment in private equity and this includes aiming for higher long-term returns and diversification of the portfolio via reduced correlation to quoted equity markets.

Size of the Private Equity Allocation Investors in private equity should take cognisance of the illiquid nature of their investment. The degree to which liquidity may be needed is usually a determinant of the size of the allocation. As a result, it is usually the case that the investors who make the largest proportional allocation to private equity from their overall portfolios are those who are capable of investing for the long term with no definite liabilities envisaged. An investor will determine the fraction of its entire portfolio that it thinks is suitable for allocation to private equity based on the need to increase targeted returns or achieve a reduction in volatility, or both.

Allocation across Private Equity Funds Investors find it difficult to avoid concentration of risk within their private equity portfolio and to get portfolio volatility under control.

Ways of Achieving Diversification Stage The different stages and types of private equity allow diversification for investors. Diversification can result in risk reduction within a private equity portfolio and is usually a major consideration. Venture capital can be further subdivided into classes across a spectrum ranging from seed stage to late stage investment. With regard to buyout funds, a distinction can be made between larger and smaller buyouts.

15 Source: EVCA Yearbook 2007. ‘Annual Survey of Pan-European Private Equity and Venture Capital Activity’.

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Figure 2.3 Private Equity Fund Life Cycle (Model fund with 17% pa lifetime IRR) 200.0

100.0 50.0 0.0

1

2

–50.0 –100.0

3

4

5 6 7 Year of fund life

Commitment Returns

8

Calls IRR

9

10

Cumulative IRR %pa

Cash ($m)

150.0

% 30 25 20 15 10 5 0 –5 –10 –15

Source: Quay Partners

Geography Geographical diversification can be achieved via investment in foreign funds and funds of funds.

Manager Selection of a variety of managers will lead to the reduction of manager-specific risk.

Vintage year Timing has an effect on the performance of funds, given that opportunities for investment and exit will be affected by external economic conditions. As a result, it has become the usual exercise to make a comparison between the performance of funds and others of the same vintage. There could be significant differences in performance from one vintage year to another. For participation to be assured in the better years, it is generally thought to be prudent to make investment time and again through vintage years, rather than timing the market by trying to predict which vintage years will yield a better performance.

Industry

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In venture investing, the main focus tends to be on technology-based industries. There can be subdivision, for instance, into healthcare or life sciences, information technology and communications. Buyout funds are more inclined

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Types of Private Equity Investment Funds

to focus on technology to lesser degree, offering exposure to industries such as financial services, retail and manufacturing.

Liquidity through a Secondary Market There is a market in interests in existing private equity funds, known as ­secondaries. A secondary offering may be made up of all or a portion of a private equity fund. A secondary market permits investors to reach a higher level of liquidity within a private equity investment portfolio, either by acquiring investments in private equity funds which have reached a later stage of their lives, or by realising investments in private equity funds by selling them to interested buyers. The secondary market has recently come of age in the USA and Europe as some institutions seek to lessen their exposure to private equity, making available the chance to buy up existing portfolios at discounted prices to buyers of the asset class. One of the keys to a secondary transaction is securing the goodwill of the underlying manager. The manager usually possesses the ability to refuse or restrict transfer of an interest in their fund. Additionally, the valuation of the underlying asset is made possible by the cooperation of the manager. As institutional private equity programmes gain traction and begin to reach maturity, the chance for investors to realise some existing commitments in order to raise cash for future commitments may become more alluring.

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Structure and Global Market Size This chapter describes the structure and the global market size of the private equity industry.

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Business Knowledge for IT in Private Equity

Introduction The growth of private equity in recent years has been nothing short of ­dramatic. In the key markets for private equity, especially the USA and the UK, private equity and public markets are no longer considered to be ‘alien investment planets’ but are starting to converge, even though this converg­ ence is gradual. Nonetheless, the industry’s potential for expansion, in these countries and beyond, is immense. The world’s best markets for private equity have similar economic characteristics – stable regulatory environments, liberal policies towards private enterprise, well-funded financial systems and an appetite for entrepreneurship. In these nations, the industry’s challenges will be those associated with growing maturity, such as demands from investors and regulators for increased disclosure and for a more transparent approach to valuation.16 Please note that the discussion of the size and structure of the private equity industry will ignore the effects of the recent credit crisis, i.e. the credit crunch. The data used in this section should not be used for forecasting or extrapolation; it is shown merely to provide a description of the state of the markets over a period of time.

Structure of the Private Equity Market A private equity firm is usually structured as a limited partnership, where the general partner receives capital from limited partners (pension funds, hedge funds, etc.), and pays the managers, advisers and lenders out of fees.

Investors in Private Equity The number and variety of groups that invest in private equity have expanded considerably to include a wide range of different types of investors. Not so long ago, the private equity market was predominantly made up of wealthy individuals committing to investments in early-stage companies. In more recent times, institutional investors with long-term commitments to the asset class are the providers of the vast majority of the capital in private equity funds and new categories of investors, such as sovereign wealth funds, have entered this market.

Intermediaries The growth in the private equity market over the past three decades is mainly due to the emergence of private equity funds engaged in raising and invest-

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16 Apax Partners. (2006). ‘Unlocking Global Value Future Trends in Private Equity Investment Worldwide’.

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Structure and Global Market Size

ing funds from investors. Private equity funds are organised mainly as limited partnerships. Under the partnership arrangement, investors who make contributions to the fund’s capital are the limited partners while professional managers running the fund act in the capacity of general partners. Intermediaries not organised as limited partnerships, such as small business investment companies and publicly traded investment companies, only play a minor role in the private equity market. About 80% of private equity investments flow through specialised intermediaries, almost all of which are in the form of limited partnerships. The remainder is invested directly in firms through co-investments (direct investing alongside private equity partnerships) and other forms of direct investments.

Issuers The amount required and the reasons for raising capital vary widely among issuers in the private equity market. Given that private equity is one of the most expensive forms of finance, issuers generally are firms that cannot tap into an alternative source of financing such as a bank loan, private placement or the public equity market. Firms seeking venture capital are usually young firms that have the potential for high growth rates. Seed or start-up capital is the term used to describe money used to purchase equity-based interest in a new or existing company which is still not operational. Venture capital also includes early-stage capital provided for companies that have started trading but have not moved into profitability or shown concrete evidence of commercial viability. Later-stage investments, where the product or service is widely available, are also considered as venture capital investments. Non-venture private equity investments include those for expansion or a change in capital structure. Public companies can also be issuers in the nonventure private equity market. These companies issue a combination of debt and private equity to finance a management or leveraged buyout. They also issue private equity to help them ride out periods of financial distress.

Agents and Advisers Agents and advisers are a fundamental part of the private equity market. They are essentially ‘information producers’ who play a role in placing private equity, raising funds for private equity partnerships and evaluating partnerships for potential investors. There are three main types of agents and advisers: ■ Those helping firms raise private equity through search and evaluation services. Their role is to advise on the structure, timing and pricing of equity issues and offer their assistance in negotiations.

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Figure 3.1 Typical Structure of the Private Equity Market ■ ■ ■ ■ ■ ■ ■ ■ ■ ■

INVESTORS

pension funds endowments foundations bank holding companies high-net-worth individuals insurance companies investment banks corporations sovereign wealth funds other investors . . .

INTERMEDIARIES Investing in private equity funds

ISSUERS Seed

Private equity fund

Fund of funds

Private equity fund Private equity fund

Direct Investments

Start-up  Expansion

Venture capital

Replacement capital Special situation Buyouts

Source: Federal Reserve Bank of Dallas, EVCA/Thomson Reuters/ PricewaterhouseCoopers

■ Those helping limited partnerships raise funds are typically restricted to large partnerships that focus on non-venture investments such as buyouts and distressed debt. Agents are seldom used for fundraising for traditional venture capital partnerships. ■ Those advising institutional investors on the placement of funds they have put aside for the private equity market. Advisers regularly specialise in evaluating and recommending limited partnership investments and sometimes offer advice on direct investments.

Financing Stage and Industry Breakdown ■ Investments – These can be categorised according to the financing stage into venture capital, buyouts and special situations. Buyouts form the majority of the investments by value as a result of the significantly larger size of such deals when compared with other investments. Venture capital accounts for the bulk of investments by number.   On a global basis, buyouts’ share of the value of private equity investments increased from 21% to 89% between 2000 and 2007. ■ Funds raised – These can be categorised according to the amount of money raised for investments.

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Structure and Global Market Size

Figure 3.2 Top Countries for Private Equity Investment and Funds Raised $bn

2007 Investment value

Funds raised

2008 Investment value

Funds raised

US UK France China India Japan Australia Others

106 50 18 11 18 15 15 85

302 61 10 11 6 5 6 89

48 32 12 13 11 10 2 61

288 65 15 13 8 3 3 55

Total

318

490

189

450

Source: IFSL estimates based on PEREP Analytics, Thomson Reuters, PricewaterhouseCoopers, EVCA, AVCJ data

■ Industry breakdown – High-tech, consumer, communications and other service sectors have attracted a large proportion of private equity investment in recent years. Figure 3.3 Regional Breakdown of Private Equity Investment % share of investments

Early stage

100

Expansion

Buyouts

2000            2007 21%

80 56% 60

64% 89%

46%

40 33% 20

33% 11%

0



UK

World

32% 4% UK

9% 2% World

Source: IFSL estimates based on PEREP Analytics, AVCJ, EVCA/Thomson Reuters/ PwC, NVCA, Ernst & Young data

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Size of the Global Private Equity Market International Financial Services London (IFSL) estimates $189bn of private equity was invested globally in 2008 (see Figure 3.4), down 40% on the previous year when $686 billion of private equity was invested. Figure 3.4 Global Private Equity Market $bn 500 Funds raised Investments 400

300

200

100



0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009-1H

Source: IFSL estimatesd based on PEREP Analytics, Thomson Reuters, PricewaterhouseCoopers, EVCA data

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The value for 2007 was a third more than in 2006 and twice the total invested in 2005 (see Figure 3.5). Together with the increase in the size of the global private equity industry, there has been a move towards greater transparency. Fund-raising reached a record US$459 billion globally for 2007, rising 5% to exceed even the US$437 billion total for 2006, according to PricewaterhouseCoopers 2008 Global Private Equity Report. The report also demonstrated the rapid growth of private equity investment in emerging markets; 8 out of the 10 fastest growing countries for private equity investment in the 10 years to the end of 2007 were either from Asia Pacific or Africa (the data does not break out Latin America or Eastern Europe by individual country).

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Structure and Global Market Size

Figure 3.5 Global Private Equity Market $bn 700

Funds raised Investments

600 500 400 300 200 100

0

2000

2001

2002

2003

2004

2005

2006

2007

Source: IFSL estimates based on PEREP Analytics, AVCJ, EVCA/Thomson Reuters/ PwC, NVCA, Ernst & Young data

Figure 3.6 Top 20 Countries (Based on Investment) US$ billion Country Ranking   1.   2.   3.   4.   5.   6.   7.   8.   9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20.

USA UK India Japan Australia France China Germany Malaysia Singapore Taiwan Sweden South Africa Netherlands Korea Sapian Hong Kong New Zealand Italy Denmark

Investment Value

Funds Raised

105.72 40.10 17.51 14.71 14.61 14.40 10.62 8.73 5.40 5.35 4.93 4.89 4.65 4.60 4.28 3.58 2.87 2.73 1.71 1.42

302.00 48.52 5.94 4.62 6.46 7.68 11.00 6.63 1.29 4.03 0.11 5.49 2.79 3.68 0.85 3.86 15.52 — 2.82 0.42

Source: The PricewaterhouseCoopers/Venture Economics/National Venture Capital Association MoneyTreeTM Survey/Thomson Financial/Buyout Newsletter/Private Equity Analyst/CVCA Annual Statistical Review/EVCA Yearbook/AVCJ Guide to Venture Capital in Asia/Venture Equity Latin America/LAVCA/SAVCA Private Equity Survey/IVC Online

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Figure 3.7 Regional Breakdown of Private Equity Investments % share 100

80

Funds raised 1% 6% 25%

Investments

10%

1% 12%

22%

20%

65%

66%

71%

2007

2000

2007

3%

2% 12%

Other Asia/Pacific

15%

Europe

60

40

68%

North America

20

0

2000

Source: IFSL estimates based on PEREP Analytics, AVCJ, EVCA/Thomson Reuters/ PwC, NVCA, Ernst & Young data

Geographic Breakdown The regional breakdown of private equity activity reveals that in 2007, North America accounted for 71% of global private equity investments (up from 66% in 2000) and 65% of funds raised (down from 68%).

North America17 The following are the statistics for the North American Region in 2007, according to PricewaterhouseCoopers Global Private Equity Report 2008: ■ $107.1 billion of private equity and venture capital were invested in North America in 2007 – an increase of 35% on 2006. ■ This is equivalent to 0.71% of the North American GDP.

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17 Data Sources: The PricewaterhouseCoopers/Venture Economics/National Vent­ ure Capital Association MoneyTreeTM Survey www.pwcmoneytree.com; Thomson Financial Investment Analytics Report (ad-hoc research) Buyouts, a Venture Economics publication www.ventureeconomics.com; The Private Equity Analyst, published by Asset Alternatives, Inc., Wellesley Massachusetts www.assetnews. com; Canadian Venture Capital Association (CVCA) Annual Statistical Review, prepared by Macdonald and Associates Limited www.cvca.ca.

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Structure and Global Market Size

Figure 3.8 Investments and Funds Raised by North America 0.77%                   0.10% Investment as % of GDP 302.0

Investments    Funds Raised 105.7 1.4   0.8

Total investment: $107.1. Total funds raised: $302.8 billion. Source: The PricewaterhouseCoopers/Venture Economics/National Venture Capital Association MoneyTreeTM Survey/Thomson Financial/CVCA Annual Statistical Review

■ $302.8 billion of funds were raised in North America in 2007 – up 18% on 2006 levels. ■ Approximately $36.7 billion were invested in technology in North America in 2007 – an increase of 17% on 2006. ■ Approximately $11.6 billion were invested in expansion stages in 2007 – a decrease of 4% on 2006. ■ Approximately $76.3 billion were invested in buyouts in 2007 – an increase of 47% on 2006.

Europe18 ■ Approximately $86.5 billion of private equity and venture capital were invested in Europe in 2007 – a 3.7% increase on 2006. ■ This is equivalent to 0.50%* of European GDP. ■ At least $92.5 billion of funds were raised in Europe in 2007 – down 30% on 2006 levels. ■ Technology investments in Europe totalled approximately $23.7 billion in 2007 – down 15% on 2006 levels. ■ Approximately $11.0 billion were invested in expansion stages in 2007 – a decrease of 17.9% on 2006. 18 Data Sources: European Private Equity and Venture Capital Association (EVCA) Survey www.evca.com. Data converted to US dollars using a fixed exchange rate from 1998 obtained from oanda.com.

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Figure 3.9 Investments by Top Five Countries 1.47%      0.56%     0.26%      1.10% 40.1

Investment as % of GDP 0.01%

14.4 8.7

4.9

4.6

Total investment: $86.5 billion. GDP*: UK – $2,727.9 France – $256.3 Germany – $3,297.2 Sweden – $444.4 Netherlands – $754.2. The top five countries account for 84% of total investment in Europe. *Based on 2007 GDP, as calculated using The World Bank Development Indicators. Source: EVCA Yearbook

■ The buyout market totalled a record $68.3 billion in 2007 – up 15.8% on 2006.

Asia Pacific19 ■ Approximately $86.3 billion of private equity and venture capital were invested in the Asia Pacific region in 2007 – up 36% on 2006 levels. ■ This is equivalent to 0.68%* of Asian GDP. ■ $51.6 billion of funds were raised in Asia Pacific in 2007 – up 25% on 2006 levels. ■ Technology investments in Asia Pacific totalled an estimated $19.2 billion in 2007 – down 1.4% on 2006 levels. ■ Approximately $17.3 billion were invested in expansion stages in 2007 – an increase of 18.4% on 2006. ■ The buyout market totalled $41.5 billion in 2007 – up 37% on 2006.

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19 Asian Venture Capital Journal (AVCJ) Private Equity and Venture Capital Review 2008 and estimates from AVCJ www.asianfn.com; Asian Venture Capital Journal (AVCJ) Guide to Venture Capital in Asia and estimates from the AVCJ.

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Structure and Global Market Size

Figure 3.10 Investments by Top Five Countries Investment as 1.50%      0.34%     1.78%      0.32%      % of GDP 17.5 2.99% 14.7 14.6 10.6 5.4

Total investment: $86.5 billion. GDP*: India – $1,171.0 Japan – $4,376.7 Australia – $821.7 China – $3,280.1 Malaysia – $180.7. *Based on 2007 GDP, as calculated using The World Bank Development Indicators. Source: EVCA Yearbook

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The Business Environment This chapter describes the business environment in which private equity companies operate.

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Introduction Private equity is now in the economic mainstream. The ownership of a number of household names is in the hands of private equity firms, which would lead us to conclude that the growth of private equity is in the ascendancy. Over the last two decades, private equity has outperformed the S&P Index, a common benchmark for stock-market investment, by up to 44%.20 Private equity investments can generate higher returns than traditional investments such as stocks and bonds. However, the investments are more fraught with risk, given that they are less diversified and require more effort to sell. Naturally, there are risks. Debt markets that have grown spectacularly and been favourable and accommodating of the industry’s leverage requirements could be negatively impacted by a major corporate collapse, a surge in interest rates or an unforeseen cataclysmic event and, as has been witnessed lately, the credit crunch. Some of the world’s economies have suddenly slowed or moved into recession. This has had a great impact on companies that use a lot of leverage and are reliant on economic resilience to meet their covenants. Exit values have plunged as stock markets have dramatically fallen. Assets bought at ­reasonable prices in the current market would appear overpriced if any of these risk factors were to come to pass. The credit crunch marks the end of the period of extraordinary liquidity that began in 2003. For most private equity firms, the implications are threefold. First, LBO debt has become harder – and more expensive – to secure. Given that the mega-buyouts of recent years were possible only as a result of lenders’ readiness to provide billions of dollars of debt financing on attractive terms, private equity firms are unlikely to participate in deals of this size until the credit markets recover. Second, the slowdown in economic growth as a result of the credit crunch will probably create a more challenging operating environment for some of their portfolio companies. And third, depressed asset prices may limit their ability to exit from some of their current investments. In spite of the impact of the credit crunch on industry, private equity firms’ ability to manage risk in cyclical markets is a vital aspect of their work and their success has been in large part due to their ability to deliver exceptional returns, regardless of market conditions, to their investors.

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20 Returns can vary depending on which firm is involved, what kinds of investment are made, and the size of the fees that investors must pay. Stephen N. Kaplan and Anoinette Schoar, ‘Private equity performance: returns, persistence and capital flows’, Journal of Finance, vol. 60, no.4, pp. 1791–1824; Julie Froud and Karel Williams, ‘Private equity and the culture of value extraction’, Centre for Research on Socio-Cultural Change, Working Paper 31, February 2007, pps. 7–8.

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The Business Environment

Environmental Factors Affecting the Private Equity Industry As part of the decision to purchase a target enterprise, private equity firms look at the usual factors which influence investments such as the macro­ economic, political, commercial, legal and regulatory environments in which the enterprise operates and its actual and potential competitive position. For this reason, the environmental factors to be discussed in this section will focus on the effect of these factors on the target company as well as the private equity firms. ■ Political and legal – Environmental factors categorised as political and legal also incorporate regulatory factors. The world’s best markets for ­private equity usually have stable regulatory environments and liberal policies towards private enterprise. In these countries, there is little or no state intervention in private enterprise that can hamper competition.   State intervention in the form of aids and open or hidden subsidies to various enterprises is harmful to smooth economic growth. They distort fair price formation, impose heavy burdens upon unsuspecting taxpayers, introduce injustices by unequally imposing and lifting economic burdens, limit genuine investment in various sectors of the economy and, in the long term, damage the health of the economy as a whole.

Impact: Private equity firms thrive better in markets where there is a freemarket and pro-competition philosophy to economic activity. This allows them to target companies that are thriving in the dominant sectors of the economies that they choose to operate in.

■ Economic – Movement of factors such as interest rates and exchange rates have a far-reaching impact on the long-term survival of companies. Movements in interest rates have an effect on the amount of money a company can borrow to fund its activities. Foreign exchange movements also affect the bottom line in terms of revenue from exports.   The performance of the global equity markets impacts on the private equity industry in the sense that if the stock markets outperform private equity then less investment capital will flow to the industry. Also, it affects the number of private equity exits from companies they invest in via an IPO or sale to listed entities therefore a strong performance in the global equity markets will impact on the number of private equity exits through IPOs. For example, according to the British Private Equity and Venture Capital Association, out of 1,735 IPOs on the London Stock Exchange Main and AIM markets between 1995 and 2006, private equity-backed IPOs accounted for 22% of the number of IPOs and 27% – or £18.9 billion – of the total sum raised.   It is also important to add the state of the credit markets as this would

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impact on the lending practices prevalent in the global economy. Also, if credit is tight, the trade and IPO exit routes are likely to grow. Impact: The state of the global economy will have an impact on the deal sizes and exit strategies adopted by private equity firms. Highly leveraged deals will be more difficult to close if economic adversity makes it hard to borrow funds.   However in a buoyant economy, private equity will flourish as target companies will be looking for outside investment to grow their businesses.



■ Socio-cultural – These factors shape perceptions of the role of private equity and vary from country to country. In a number of countries, private equity firms are accused of asset stripping for personal gain, sacking ­workers and cutting off pensioners. Private equity firms, on the other hand, see their role as empowering business leaders as they seek to make changes as well as offering a capital market in parallel to publicly quoted companies.

Impact: As private equity becomes more mainstream and the concept is embraced outside the traditional financial centres, it remains to be seen how proprietors of their target companies, the unions and the workforce view the overtures of private equity companies in regard to investment in their companies.

■ Technological – As more corporations are acquired by private equity firms, IT management staff of these corporations are bracing themselves for unknown impacts on IT strategy, budgets and in-flight initiatives. They are unsure as to whether the new owners will bring in their own IT leadership, focus on cost restructuring, or redirect current technology budgets and programmes. In addition, they are unsure as to how closely the ­operating units of the acquiring private equity firm will engage with day-to-day IT governance activities.   In the current business environment, the IT budget is one of the most significant components of a company’s capital and operating budgets. Impact: With a surge in private equity investment over the past two decades, more and more CIOs of potential target companies are learning how to effectively align the strategies, styles and cultures of IT organisations with the management principles that characterise most PE firms. They realise that they have to optimise their companies’ IT portfolios for top-line revenue growth.   Private equity firms, on the other hand, can use their action orientation and willingness to take measured risks to achieve high-value returns and also cut through organisational politics and refocus IT’s efforts.



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The Business Environment

Profiles of some Major Players KKR Kohlberg Kravis Roberts & Co (commonly referred to as KKR) is one of the largest private equity firms. It is headquartered in New York City, USA, and has offices in San Francisco, Menlo Park, Houston, Washington DC, London, Paris, Hong Kong, Tokyo, Beijing and Sydney. KKR was founded by Jerome Kohlberg, Jr., and cousins Henry Kravis and George R. Roberts, all of whom had previously worked together at the now defunct Bear Stearns. It began operations on 1 May, 1976 as a private equity firm specialising in leveraged buyouts. By 1977, the firm had completed its first acquisition (A. J. Industries) with capital raised from a small group of investors. This company, a Los Angeles-based diversified manufacturer of transportation, military, and other products, had a total market value of $26 million. After eight years, KKR sold the investment, providing returns to its investors. Other notable transactions completed by the firm include: ■ Alliance Boots in 2007 for £12.4 billion; ■ Energy Future Holdings Corp. (formerly TXU Corp.) in 2007 for $48.4 billion; ■ NXP in 2006 for E9.0 billion; ■ Legrand in 2002 for E9.0 billion; ■ RJR Nabisco in 1989 for $31.4 billion.

Carlyle Carlyle is one of the world’s biggest private equity firms, headquartered in Washington DC in the USA. It was founded in 1987 with $5 million and 10 employees. The firm’s 500 investment professionals manage more than $81 billion in assets from 33 offices around the world. Carlyle has over 1,200 investors in 68 countries, $91.5 billion under management and 64 funds across four investment disciplines (buyouts, growth capital, real estate and leveraged finance).21 Carlyle was founded in 1987 by Stephen L. Norris and David M. Rubenstein.22 The company was reported to have its best two years in 2006 and 2007, returning $19.1 billion in equity and profit to its investors, which also included financial institutions and high-net-worth individuals.23 The firm has historically been known as the most politically connected private equity firm, 21 Carlyle. ‘Firm Profile’. Available from www.carlyle.com/Company/item1676. html. 22 Briody, Dan. (2003). The Iron Triangle: Inside the Secret World of the Carlyle Group. New York: John Wiley & Sons. 23 The Carlyle Group ‘2007 Annual Report’.

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exploiting its connections with the likes of George Bush Snr. and John Major to raise funds and secure government contracts. After controversy surrounding its political ties, Carlyle reduced its exposure to companies reliant on government contracts, particularly defence contracts, and focused on diversifying its portfolio.24 Carlyle has also evolved from a specialist in deals under $1 billion to become ‘a big game hunter’, cutting a number of multibillion-dollar club deals with fellow top-five private equity firms since 2005.25 Carlyle invests in a wide range of industries, including aerospace and defence, automotive and transportation, consumer and retail, energy and power, health care, industrial, real estate, technology and business services, and telecommunications and media. Either alone or as part of club deals, ­Carlyle has bought out such well-known companies as Loews Cinemas, Dunkin’ Brands (Dunkin’ Donuts and Baskin Robbins), and Del Monte Foods. At present, Carlyle’s portfolio includes approximately 140 companies,26 which in turn employ more than 200,000 workers and have $68 billion in sales. Major recent investments made by Carlyle include:27 ■ The 2007 purchase of US gas pipeline company, Kinder Morgan, with Riverstone Holdings and other partners for $20 billion; ■ The purchase of HD Supply, US distributor of industrial supplies products, with partners for $8.5 billion in 2007; ■ The acquisition of Applus Servicios Tecnológicos, Spanish provider of technological testing and inspection services, in 2007 for E1.3 billion; ■ The acquisition in 2007 of a 49% stake in Chinese steel-pipe supplier, Yangzhou Chengde Steel Tube Company, for $139 million.

TPG TPG Capital (formerly Texas Pacific Group) is a large private equity investment firm headquartered in Fort Worth and San Francisco. The company’s focus is on leveraged buyout, growth capital and leveraged recapitalisation investments in distressed companies and turnaround situations. The firm was established in 1992 by David Bonderman, James Coulter and William S. Price III, shortly after turning twice-bankrupt Continental Airlines into a serious contender in the airlines market. Since its inception, the firm has raised more than $50 billion of investor commitments across more than 18 private equity funds.28

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24 James K. Glassman. ‘Big Deals’. June 2006. Washingtonian. Available from www. thecarlylegroup.com/eng/presskitfiles/1597_Web_no_pics.pdf. 25 Emily Thornton. ‘The Carlyle Group hunts bigger prey’. Business Week.com http://images.businessweek.com/ss/07/02/0201_carlyle_deals/ 26 Glassman, James K. ‘Big Deals’. June 2006. Washingtonian. Available from www. thecarlylegroup.com/eng/ 27 Ibid. 28 www.fundinguniverse.com/company-histories/Texas-Pacific-Group-IncCompany-History.html.

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The Business Environment

TPG’s industry areas of focus are airlines, media and telecommunications, industrials, technology and health care. Either on its own or as part of club deals, TPG has bought out such well-known companies as the J. Crew Group, Neiman Marcus, Burger King, MGM, and Harrah’s Entertainment, the world’s largest gaming company. TPG’s most notable 1997 investment was its takeover of J. Crew. TPG acquired an 88% stake in the retailer for an estimated sum of $500 million.29 Among TPG’s other notable transactions are: ■ Its investment in Piaggio SpA, the Italian manufacturer of Vespa motor scooters, in 1999; ■ The 2005 acquisition of SunGard Data Systems in a club deal for $11.4 billion; ■ The acquisition of Biomet, an orthopedic devices maker, in a club deal with Blackstone, KKR and Goldman Sachs Capital Partners in 2006 for $10.9 billion; ■ The 2006 acquisition of Harrah’s Entertainment with Apollo Management for $27.8 billion.

3i The 3i Group plc is a private equity firm headquartered in London, UK. The company was founded in 1945, as the Industrial and Commercial Finance ­Corporation (ICFC), by the Bank of England and the major British banks for the purpose of providing long-term investment funding for small and mediumsized enterprises. Its foundation was inspired by the government and resulted from the recognition in the 1930s, given new impetus in the post-war era, that smaller businesses faced a gap in available corporate finance: the banks were unwilling to provide long-term capital and the companies were too small to raise capital from the public markets. In 1983, the company was renamed Investors in Industry, commonly known as 3i. The 3i Group was created in 1987 when the banks sold off their stakes to form a public limited company. In 1994, the company was floated on the London Stock Exchange with a market capitalisation of £1.5 billion.30 Notable deals by 3i include:31 ■ The 2008 E730m buyout of Global Garden Products; ■ In 2005, divesting the world’s largest foreign exchange specialist, Travel­ex, in a £1bn transaction, generating a 10-fold return on its investment; ■ The sale of Go Fly, a low-cost airline, to easyJet for £374 million in 2002; 29 Steinhauer, Jennifer. ‘J. Crew Caught in Messy World of Finance as It Sells Majority Stake’. New York Times, 18 October, 1997. 30 3i. ‘The History of 3i’. Available from http://www.3i.com/about3i/history-of3i.html. 31 Ibid.

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■ In 2001, leading a JP¥15bn management buyout of Vantec, the ex-­Nissan Motors subsidiary, the first ever western-style management buyout in Japan.

Bain Capital Inc. Bain Capital, headquartered in Boston Massachusetts in the USA, is a private equity firm that was established in 1984. As of March 2007, the firm had raised $13 billion in private equity leveraged buyout funds.32 Bain Capital is a staple of the club deal circuit and, historically, about a half of Bain’s deals have been club deals.33 Bain ‘clubbed’ with Texas Pacific and Goldman Sachs to buy Burger King for $1.5 billion. Bain contributed $190 million in equity. Two dividend recapital­isations in 2005 and 2006 resulted in the Burger King club participants recouping nearly all of their original equity investment.34 In May 2006, the buyout group took Burger King public. Following a second share offering in February 2007, Bain still owned 19% of the company, worth more than $560 million. According to The Deal, the two stock offerings and dividend recaps earned Bain and the other Burger King investors four times their initial investment.35 Other notable deals by Bain Capital include: ■ The acquisition, with KKR and Merrill Lynch, of HCA, a for-profit hospital chain, in 2006 for $33 billion; ■ The 2006 acquisition of Michael Arts and Crafts, an arts and crafts material retailer, in a $6 billion club deal with Blackstone; ■ The acquisition of fast-food retailing chain, Dunkin’ Brands, with Carlyle and Thomas H. Lee for $2.4 billion.

Data Providers Private Equity International Private Equity International (PEI) is a financial information group dedicated to alternative assets globally. The firm was formed in London in November 2001, when a team of managers at financial media group Euromoney Institutional

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32 Katie Benner, Telis Demos, Corey Hajim, Jia Lynn Yang. ‘The Power List’. Fortune. 5 March,2007. 33 Katie Benner. ‘The Power List’. Fortune. 16 February, 2007. ‘Going Clubbing?’ The DailyDeal, 31 August, 2006. 34 ‘Value of Bain stake in Burger King’, Burger King 424(b)(4), page 1, filed 2 February, 2007. 35 Bernard Condon. ‘Is the Warner deal the peak of LBOs?’ Forbes Global. 6 June, 2005.

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Investor PLC, with the assistance of a number of US-based investors, bought out a group of assets that centred on the website PrivateEquityOnline.com. At the time, the new company was known as InvestorAccess and the plan was to grow a specialist publishing business with a focus on alternative assets, especially private equity. From the beginning, the aim was to be close to both the holders of institutional capital (investors) and those managers involved in alternative assets (funds). Private Equity International, the company’s first magazine, was launched in December 2001.Three more magazines, PEI Manager, Private Equity Real Estate and PEI Asia, were launched thereafter. PERE Connect, a global online service for tracking investors in private equity real-estate funds, is provided by the company. This service allows users to consult investor-specific news coverage, see who is committing to which funds and be alerted about personnel changes amongst the institutions covered. In essence, it is a tool for fund-raising and investor relations. PE Connect, a database that tracks investors in private equity and venture capital funds globally, is also provided by the company.

The Financial Times The Financial Times (FT) is an international business newspaper printed on distinctive salmon-pink broadsheet paper. The periodical is printed in 22 ­cities: London, Leeds, Dublin, Paris, Frankfurt, Stockholm, Milan, Madrid, New York, Chicago, LA, San Francisco, Dallas, Atlanta, Miami, Washington DC, Tokyo, Hong Kong, Singapore, Seoul, Dubai and Johannesburg. It offers news about the private equity industry in the In-depth section of www.ft.com to subscribers and also in the Alphaville section of the website.

Reuters Professional Publishing With a portfolio of market-leading titles and online services, Reuters Professional Publishing provides authoritative and unbiased market intelligence to private equity professionals, amongst other professionals throughout the world. Its suite of products and services caters for every type of information requirement – from the weekly in-depth capital markets coverage of International Financing Review (IFR) through to the searchability and functionality of their online products and on to the real-time, minute-by-minute commentary and analysis of IFR Markets. With unparalleled access to key industry decision makers, its range of print and online services ensures that M&A, private equity, venture capital and buyout professionals are kept fully up to date with the very latest market developments.

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European Venture Capital Journal (EVCJ) EVCJ is a European venture capital and private equity magazine. Published 10 times a year, it provides data and analysis on key developments in the private equity and venture capital markets. It covers every activity, from fund-raising through to exits. EVCJ has interviews with leading professionals as well as all the key people moves. Its subscribers will also benefit from a list of companies seeking buyers in Europe as well as announced deals every month; they are sorted by country, right across Europe. EVCJ’s regular industry supplements on topical issues such as mezzanine finance, MBOs, and new legal and regulatory developments, are designed to provide new insight into the key developments currently driving the European market in private equity and venture capital.

MoneyTreeTM Report36 The MoneyTreeTM Report is a quarterly study of venture capital investment ­activity in the United States. It is a collaboration between PricewaterhouseCoopers and the National Venture Capital Association based upon data from Thomson Reuters and is an industry-endorsed research tool. The MoneyTreeTM Report is a source of information on emerging companies that receive financing and the venture capital firms that provide it. The study is widely used by the financial community, entrepreneurs, government policymakers and the business press worldwide. Contained in the reports are the following: ■ ■ ■ ■ ■

Industry definitions; Sector definitions; Stage of development definitions; Type of financing/financing sequence; Geographical definitions.

The MoneyTreeTM Report measures cash-for-equity investments by the professional venture capital community in private emerging companies in the USA.

AltAssets AltAssets is a service offered by Almeida Capital, as part of its research activities, that is widely available in order to inform and connect the global private equity community. Through AltAssets, Almeida Capital provides news and research to more than 1,000 institutional investors and 2,000 private equity and venture capital firms worldwide. The service receives over 434,000 ­visits

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36 Source : www.pwcmoneytree.com/MTPublic/ns/nav.jsp?page=definitions.

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from industry professionals each month, downloading up to three million pages of information.37 The AltAssets website is an online news and information service. It is a private equity site targeted specifically at institutional investors, even though it is also visited by several private equity firms and service providers. It contains up-to-the-minute news coverage of the industry, plus opinions and analysis of the trends apparent in today’s private equity market – all written by Almeida Capital’s team of in-house journalists and researchers.

FINalternatives FINalternatives is an independent source for news on the alternative investment industry. Each week, FINalternatives is delivered to subscribers’ inbox in a PDF newsletter. In addition, stories about the private equity industry are posted daily on the website. Also included on the website are a library, a directory, a job board, a listing of indices and reports and also a listing of events relating to the private equity industry.

Library House Ltd. The Library House, Ltd. is involved in the discovery, research and profiling of information on ventures in Europe. The company’s products include: ■ VenturePedia – A database that contains information and analysis on private European companies; ■ VentureCast – A newsletter that provides a snapshot of the latest news and highlights of the venture-backed private market; ■ VentureInsight – Research on sectors, ventures and individuals; ■ VentureConnect – Brings together entrepreneurs, investors and advisers; ■ VentureGauntlet – Analysis on a venture’s readiness for investment.38

The Journal of Private Equity (JPE) The Journal of Private Equity provides in-depth analysis on investments in both venture capital and private equity buyout funds. The coverage includes early-stage, mezzanine and later-stage private companies and financings, including investment strategies, liquidity options, selection of management teams, acquisition tactics, and specialised legal, accounting, board and turn­ around issues for private equity players on both the limited and general ­partner sides. 37 Source: www.altassets.com/aboutus.php. 38 Source: http://investing.businessweek.com/research/stocks/private/snapshot. asp?privcapId=6207677.

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JPE gives private equity professionals the techniques and strategies behind successful venture capital and private equity deals. Articles include financial applications of structuring and exit strategies, cross-border issues, industry analyses, management methods and more. Readers come from ­venture ­capital funds, merchant banks, LBO funds, private investment divisions of commercial banks and corporations, and equity investment firms.

Private Equity Insider Private Equity Insider is a newsletter that provides information on the secret developments involving operators of buyout funds, venture capital firms, funds of funds, secondaries and other types of private equity vehicles. It is used by, among others, managers of private equity funds, fund-of-fund operators and high-net-worth individuals who target private equity vehicles. This newsletter covers:39 ■ Marketing: Capital-raising innovations, successes and failures; ■ Infighting: Clashes between fund-management principals; ■ Fund launches: The early word on plans to establish new buyout and venture capital funds, as well as secondary-market entities, funds of funds and real-estate opportunity funds; ■ Investor relations: Scoops on sudden shifts in investor allocations and on squabbles between LPs and GPs; ■ Market trends: Early warning signs that the pendulum is swinging from times when cash-flush fund managers are calling the shots to periods when the LPs hold sway; ■ Career opportunities: Fresh news on fund managers, institutional investors and vendors preparing to build up or scale back their staff – as well as key personnel moves made every week; ■ Valuation standards: The latest efforts in the industry’s ongoing struggle to develop a uniform approach for valuing the holdings of private equity funds; ■ Competition among service providers: Jockeying of placement agents and other vendors to win important mandates from fund operators and investors; ■ Manager assessments: Intelligence that investors need to identify the upper echelon of private equity fund managers.

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39 Source: www.peinsider.com/Public/NewsLetter/Aboutus/index.cfm.

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Indices The Silicon Valley Venture Capital Confidence Index The quarterly Silicon Valley Venture Capitalist Confidence Index is based on an ongoing survey of venture capitalists operating in the San Francisco Bay Area/Silicon Valley in the USA. According to the Silicon Valley Venture Capitalist Confidence Index report, the Index measures and reports the opinions of professional venture capitalists on their estimation of the high-growth venture entrepreneurial environment in the San Francisco Bay Area over the next 6–18 months. The intention of publishing a recurring confidence index of professional venture capital investors is to provide a continuous leading indicator of the general health of the high-growth new venture environment. This progressive indicator of Bay Area high-growth entrepreneurial activity is expected to act as a fair proxy for new venture activity across the United States, as the San Francisco Bay Area is the largest source of venture capital in the nation.

Private Equity Index (PRIVEX) PRIVEX is an index developed by Société Générale in collaboration with Dow Jones Indexes. Included in the PRIVEX are the 25 largest and most liquid listed private equity companies. The index covers the various regions where private equity companies are active, such as Asia, Europe and the USA as well as the various activities of the sector. Figure 4.1 PRIVEX Country Weighting at Launch

Asia

Europe (including UK)

US

UK

5%

10%

Source: Dow Jones Indexes

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15%

20%

25%

30%

35%

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Figure 4.2 Private Equity Weighting in PRIVEX Other

Venture capital

Buy-outs

10%

20%

30%

40%

50%

60%

70%

Source: Dow Jones Indexes

The index methodology is such that it is market capitalisation weighted, even though the weighting of any single component company of the PRIVEX is restricted to 15% to make sure that there is sufficient diversification between the index members. The composition of the PRIVEX is reassessed every six months by the Dow Jones Indexes. The private weighting in PRIVEX is shown in Figure 4.2. For companies to be eligible for admission into the index, they must have a minimum market capitalisation of US$200 million. Additionally, there must be adequate liquidity in the trading of shares of member companies. There is an adjustment of the capping factors for the individual index members every quarter. The base currency of the PRIVEX is Euros.

Street Private Equity Index Street Private Equity Index is an index that leverages the private equity investment data collected by State Street Investment Analytics’ Private Edge Group, which provides detailed analyses of customers’ private equity portfolios through an automated web-enabled environment. Given that it is not reliant upon voluntary reporting of cash flows from general partners, the State Street Private Equity Index does not have the reporting bias prevalent among many other industry indexes. The index includes data from more than 1,400 private equity partnerships with a total fund size in excess of $1.2 trillion. This data covers the private equity investments of the client base of the Private Edge Group including ­public and private pension funds, endowments, foundations and fundof-funds ­ representing more than 4,000 commitments totalling over $250 ­billion.40

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40 Source: ‘State Street Private Equity Index’. Available from www.statestreet.com/ analytics/SSIA_pei.pdf.

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Overview of Buyout This chapter discusses the concept of buyout in the private equity industry. Also included are discussions on the theoretical underpinnings of leverage buyouts and the different types of buyout transaction.

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Introduction Buyout is a term used to describe the purchase of a company’s shares in which the acquiring party gains controlling interest of the targeted firm. Incorporating a buyout strategy is a widespread technique used to gain access to new markets and is one of the most popular methods for inorganically growing a business. A firm typically ‘buys out’ a company to take control of it. A buyout can take the form of a leveraged buyout, a venture capital buyout or a management buyout. Where the company being bought out is a public company, a buyout is often called a ‘going private’ transaction.

Different Types of Buyout Transaction Management Buyout (MBO) The typical buyout has always been a management buyout (MBO). Put quite simply, an MBO is a form of acquisition whereby a company’s existing man­ agers acquire a large part or all of the company. This will usually require financial support from outside the business, such as from bankers or private equity firms. MBOs can vary greatly in their size and while some can be straightforward transactions, others can be more complex. The main purpose of this type of buyout from the managers’ point of view may be to save their jobs, either if the business has been scheduled for closure or if an outside purchaser would bring in its own management team. In addition, they may also want to maximise the financial benefits they receive from the success they bring to the company by taking the profits for themselves. This is usually a way to ward off aggressive buyers. The key feature of all MBOs is that the members of the team put in some of their own personal funds in exchange for an equity interest (a stake) in the business. MBOs usually see the existing owners sell all or most of their stakes in the business to the new managers and their fellow investors, who could be private equity firms.

Example of an MBO transaction

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The BizBean furniture chain was saved from bankruptcy by a last-minute management buyout – funded by the private equity group that owned the business. Like many other retailers, BizBean, which employs 5,000 staff and owns the Esscale and BizTall brands, has been battered by the consumer and housing downturn, and by rising costs. Invest Equity Partners, which purchased the struggling company two years ago for £1 plus debts, is providing a cash ‘dowry’ to enable the management,

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Figure 5.1 The Ten Largest Buyout Transactions Approximate Acquisition Estimated Date Acquired Private Equity Price number of Announced Company Firm(s) ($bn) Employees 2/24/2007

KKR, TPG

45

7,262

11/20/2006 Equity Office Properties

Blackstone

39

2,3000

7/24/2006 HCA Inc.

Bain, KKR, Merrill Lynch

33

186,000

04/02/2007 First Data Corp

KKR

29

29,000

Harrah’s Apollo Management, 28 Entertainment Inc. TPG

85,000

10/2/2006

TXU Corporation

11/16/2006 Clear Channel Communications

Bain, Thomas H. Lee

27

26,500

8/28/2006 Kinder Morgan

Carlyle, Goldman Sachs, AIG, Bill Morgan, Fayez Sarofim, Mike Morgan, Riverstone Holdings, Richard D. Kinder

22

8.481

9/15/2006 Freescale

Blackstone, Carlyle, Permira Advisors, TPG, Stone Tower Capital

18

22.700

1/23/2006 Albertson’s

Cerberus Capital, Kimco Realty and others including SuperValu and CVS

17

234,000

11/13/2005 Hertz

Carlyle, CD&R, Merrill Lynch

15

31,500

Source: Service Employees International. ‘Union Behind the Buyout’. April 2007 Report

led by chief executive Glen Jones, to take control of the business. The sum is understood to be around £40 million plus working capital. Most of that payment will be immediately handed over to the landlords of the group’s 200 retail stores as the quarterly rent day is due for payment, with BizBean due to pay £29 million.

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Management Buy-in (MBI) The management buy-in (MBI) derives from the MBO. MBI occurs when a manager or a management team from outside the company raises the required finance, buys it, and becomes the company’s new management. A management buy-in team often competes with other purchasers in the search for a suitable business. Typically, the team will be led by a manager with considerable experience at managing director level. The difference between the MBI and MBO is in the position of the purchaser: in the case of a buyout, they are already working for the company while in the case of a buy-in, however, the manager or management team is from an external source. MBIs are traditionally more difficult to fund than MBOs. The lenders have to be convinced that the MBI team (or MBI candidate) have adequate experience and the capability to deliver. An MBI candidate would normally have to have the following attributes: ■ A proven successful business background; ■ Business leadership skills coupled with drive and enthusiasm; ■ The wherewithal to risk personal capital.

Buy-In Management Buyout (BIMBO) It can be deduced from the acronym that a buy-in management buyout is a combination of a management buy-in and a management buyout. In the case of a buy-in management buyout, the team that buys out the company is a combination of existing managers and individuals from outside the company who will join the management team following the buyout. This arrangement provides the best of both worlds of a buy-in and a buyout. In practice, the transfer will be made much more efficiently, given that the existing members of management are already familiar with the business that is being taken over. The management buy-in most probably will bring in outside individuals with a specific expertise that is lacking in the organisation and will benefit the firm a great deal.

Example of BIMBO transaction

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One of the UK’s leading large format, point-of-sale (POS) printing companies, Brighton-based Essgraphics Limited (Essgraphics), was sold to a management buyout/buy-in team in a £10 million deal backed by Europe’s leading venture capital company, 10 Investment Partners, who invested £5 million for a majority stake with the balance of equity being taken by the management. The BizWest Bank’s Corporate & Structured Finance team in London provided debt facilities of £4.1 million for the transaction. The rationale for the deal is the result of Essgraphics’ significant growth in recent years. This deal creates a platform for further growth and development

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of the business. Essgraphics has a blue-chip client base and is well invested in the latest print technologies.

Take Private ‘Take private’ transactions are also known as ‘public to private’ or ‘P2P’. When a ‘take-private’ transaction occurs, a large private equity group, or a consortium of private equity firms, buys or acquires the stock of a publicly traded corporation. Given that a number of public companies have revenues of ­several ­hundred million to several billion dollars per annum, the acquiring private equity group typically needs to secure financing from an investment bank or related lender that can make available enough loans to help finance (and complete) the deal. The newly acquired target’s operating cash flow can then be used to pay off the debt that was used to make the acquisition ­possible. These types of transaction may take on a different form depending on the country where the deal is executed. In the UK, for instance, ‘take private’ deals normally involve a management team of the target public company (the management buyout (MBO) team) approaching a private equity house to arrange debt and equity funding for an acquisition of the target (usually a ‘small to mid cap’ company). While management-led deals such as this still take place, ‘take private’ deals have become more commonly initiated by the private equity house itself and could also entail the private equity house introducing additional or replacement ‘buy-in’ management.41 The size of company targeted by this type of transaction has increased steadily over the years, even though the biggest ‘take private’ transactions are still of lower value than the very biggest mergers and acquisitions transactions. It is worth noting that participants, industry watchers and advisers sometimes label a number of different types of transaction as ‘take private’ while none of them constitutes a ‘take private’ in private equity terms. For instance, according to Freshfields Braukhaus Deringer, a global law firm: ‘a straight delisting of a thinly traded company is not a ‘take private’ in the private equity sense of the term nor is a straight bid (with no external equity or debt finance) by the majority shareholders of a public company for the shares of the ­minority’.

Why do corporations go private? Investment banks, financial intermediaries and senior management build relationships with private equity firms with a view to exploring partnership and transaction opportunities. As acquirers typically pay at least a 20–40% ­premium over the current stock price, they can entice CEOs and other managers of public companies – who are often heavily compensated when their company’s stock appreciates in value – to go private. Additionally, share­ 41 Freshfields Bruckhaus Deringer (July 2003). ‘Take Private Transactions in the UK’.

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holders, particularly those who have voting rights, often apply pressure to the board of directors and senior management to close a pending deal so that their equity holdings will go up in value. Many stockholders of public companies are also short-term institutional and retail investors, and realising premiums from a ‘take private’ transaction is often a low-risk way of securing returns.

Other commercial drivers for ‘take private’ deals There are a number of commercial drivers behind the investment by private equity investors in ‘take private’ deals that have made ‘take private’ activity a popular mergers and acquisition method. External factors Target companies are often companies neglected by the market that over the years have suffered a significant fall in their share price relative to their underlying value. The increasing concentration of funds in the institutional fund management community, an increasing demand for investments in corporates with larger market capitalisations and greater liquidity, and the progressive shift of investment banks’ research away from smaller companies are all cited as factors driving valuation discounts.42 A vicious circle (loss of research and trading coverage leading to a reduction in the number of fund managers covering the stock) can increase volatility and result in a further reduction in liquidity. However, such companies can present attractive targets to private equity houses, especially companies with robust underlying businesses and strong cash flows. Internal factors As well as external pressures, internal factors may also be relevant to the ‘take private’ decision. The target company may need to undergo a fundamental reorganisation or a restructuring of its debt/equity financing away from public scrutiny or create an exit route for major shareholders where no other ­practicable alternatives are available. A typical real-world example of a ‘take private’ transaction is the purchase of Sears retail chain (a different Sears from Sears, Roebuck and Company) for £538 million in 1999 by Philip Green, a British billionaire businessman. Another example is the £230 million hostile takeover of Esporta by Duke Street Capital, the European private equity firm in 2002.

Roll-up During the previous two decades, improvements in information technology and the advent of outsourcing substantially increased the optimal scale of

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42 Ibid.

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firms in a large number of fragmented industries.43 These encouraged private investors to target an industry that is highly fragmented, purchase lots of small operators and put them together. The obvious benefit of this type of approach is that it is possible to increase profit exponentially by improved marketing efforts, better management and economies of scale. Another type of roll-up transaction is the one which was developed in the United States in the mid-1990s and which saw a period of frenetic activity, the roll-up initial public offering. Roll-up IPOs (i.e. ‘roll-ups’) are transactions in which a shell company goes public while simultaneously merging with a number of other firms that operate in the same industry. This strategy does not require private invest­ ors to finance the transaction, nor does it need an established large player in the industry. The IPO provides the company with liquid shares and cash, which can then be used as payment in the purchase of the companies that are merged. In addition, the shares, together with the cash proceeds, can also be used to make further acquisitions in an attempt to continue the consolidation process started at the IPO stage. Thus, a roll-up IPO allows a company to fund an extreme level of growth over a very short time horizon.44 Industry experts cite several reasons for the increased interest in roll-ups in the mid-1990s including: 1. A number of private equity partnerships found that roll-ups were the ­easiest way to achieve industry consolidation in industries without a natural leader. 2. A number of potential investors in the vibrant IPO market of the 1990s were quite open to new ideas. 3. Many small business owners were ready for retirement and did not have natural succession plans in place, making the possibility of selling out to a public company an interesting alternative. 4. The growth in corporate outsourcing offered a unique opportunity for companies in the service industry. 5. Improvements in information technology meant that greater economies of scale could be achieved through consolidation. 6. Roll-up removed the personal guarantees of debt by the original owners of the founding companies. An exciting feature of roll-ups is that the sponsors do not need lots of capital to initiate the transaction. The proceeds from the IPO pay for the businesses and organising fees, and finance growth. With good economic sense (the proper industry must be chosen) and lots of sweat equity,45 a firm can 43 Brown, David T. and Ryngaert Michael D. 1991. The mode of acquisition in takeovers: Taxes and asymmetric information, Journal of Finance 46, 653–669. 44 Keith C. Brown et al. ‘Corporate Governance, Incentives, and Industry Consolid­ ations’, October 2003 Dradt Paper. 45 The equity that is created in a company resulting from hard work by the owner(s).

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head up a multimillion-dollar company with almost no financial investment. Roll-ups have become popular, given that very many small business owners are approaching retirement and the roll-up mechanism provides a good way to sell their business.

Leveraged Buyout (LBO) This type of buyout transaction will be discussed in more depth than the ­others and the discussion will include the history and theoretical aspects as well as the structure and organisation.

Overview An LBO is one of the most popular types of private equity financing. In an LBO transaction, a company takes out a loan from a private equity firm to fund the acquisition of a division or another company. The loan is typically secured by the cash flows or the assets of the company being acquired. After a company is acquired in an LBO, it is sometimes broken up and sold in pieces, and the cash generated is used to pay down the high leverage of the transaction. This break-up strategy was much more popular during the 1980s than it is in the new millennium. Given that companies now are more expensive, most LBO deals focus more on buying companies and creating value-added from their assets, as opposed to breaking up the companies with a view to selling off their parts. In the 1980s, a lot of attention was focused on LBO firms and their professionals, but not all was flattering. LBO activity grew rapidly throughout the 1980s, beginning from a basis of four deals with a cumulative value of US$1.7 billion in 1980.46 A leveraged buyout is akin to buying a house with a mortgage. With a down payment of 10% in cash, an individual can get a mortgage for the remaining 90% of the cost of the house, using the house itself as collateral. In a similar way, a private equity firm could take $300 million raised from investors to buy out a company worth $1 billion. In order to complete the deal, the buyout firm uses the $300 million in equity plus the value of the company as collateral to borrow the remaining $700 million required to finance the ­purchase of the company. Lenders who provide the debt to finance leveraged buyouts seek to ensure portfolio companies have adequate cash flows to service the payments on the debt, just like mortgage lenders who verify that borrowers have sufficient income to cover their mortgage payments. In the event that a portfolio company that has undergone a leveraged buyout cannot make its debt

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46 Source: Jonathan Olsen (2002). ‘Note on Leveraged Buyout’. Tuck School of Business at Dartmouth Note.

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Overview of Buyout

payments, the company can be forced into bankruptcy by its creditors. Under most circumstances, however, in contrast to a home mortgage, the private equity firm and its investors who funded the equity portion of the deal are not liable to repay this debt.

History of LBO While there are conflicting accounts as to when the first leveraged buyout was carried out, there is a general consensus that the first early leveraged buyouts were carried out in the years after World War II. Before the 1980s, the leveraged buyout (hitherto referred to as ‘bootstrap’) acquisition was for a number of years merely a vague financing method. The years after World War II saw America’s corporate management consider it prudent to keep corporate debt ratios low, given that the Great Depression was still relatively fresh in their minds. As a consequence, for the first 30 years after World War II, only a few American companies depended on debt as a major source of funding. At the same time, a trend emerged whereby American businesses began a wave of conglomerate building, which started in the early 1960s. Executives placed subordinates and friendly ‘outsiders’ on their board of directors and busied themselves with extensive empire building. As a result, the ranks of middle management were enlarged and corporate profitability was on the wane. It was this environment that give rise to the birth of the modern LBO. In the latter part of the 1970s and the early 1980s, newly founded firms such Kohlkberg Kravis Roberts and Thomas H. Lee spotted an opportunity to make profits from inefficient and undervalued corporate assets. A lot of public companies were trading at a discount to net assets, and a number of early leveraged buyouts were inspired by profits that existed from purchasing the companies, breaking them up and selling off the pieces.47

Theory of the Leveraged Buyout In spite of the uniqueness of every leveraged buyout with regard to its particular capital structure, the use of leverage for completion of the purchase of a target company is one aspect that leveraged buyout transactions have in common. In an LBO, the private equity firm acquiring the target company will finance the acquisition with a mixture of debt and equity in similar way to an individual using a mortgage loan to buy a house. In the same way that a mortgage is secured by the value of the house being bought, some fraction of the debt incurred in an LBO is secured by the assets of the acquired business. However, unlike a house, the bought-out business generates cash flows which 47 Isn’t this reminiscent of the activities of Edward Lewis, the character played by Richard Gere, in the 1989 movie ‘Pretty Woman’, which also starred Julia Roberts and Hector Elizondo?

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are used to service the debt incurred in a buyout, which means the acquired company helps pay for itself (hence the term ‘bootstrap acquisition’).48 Using a considerable amount of borrowing to finance the buying of a ­company has a number of advantages, but also has risks. Financial distress is the most evident risk that is related to leveraged buyouts. Unanticipated occurrences like recession, litigation or changes in the regulatory environment can result in difficulties meeting scheduled interest payments, technical default (the violation of the terms of a debt covenant) or outright liquidation. Weak management in the target company or misalignment of incentives between management and shareholders can also threaten the ultimate ­success of an LBO. There are many advantages associated with the use of leverage in acquisitions. Large interest and principal payments can compel management to improve performance and operating efficiency. This ‘discipline of debt’ can also compel management to place emphasis on certain initiatives, for instance divesting non-core businesses, downsizing, cost cutting or investing in technological upgrades that might otherwise be deferred or completely rejected. In this way, the use of debt becomes not just a financing technique, but also a tool to enforce changes in managerial conduct. Another merit of the leverage in LBO financing is that as the debt ratio increases, the equity portion of the acquisition financing reduces to a level at which a private equity firm can buy a company by putting up anywhere from 20–40% of the total purchase price. Private equity firms normally invest alongside management, encouraging (if not requiring) top executives to contribute a significant fraction of their personal net worth to the deal. By requiring the target’s management team to commit to investment in the acquisition, the private equity firm guarantees that there will be alignment of management’s incentives with their own. In addition to the debt financing element of an LBO, there is also an equity element. Private equity firms usually invest alongside management to ensure the alignment of management and shareholder interests. In large LBOs, private equity firms will at times team up to create a consortium of buyers, thereby reducing the amount of capital exposed to any one investment. As a general rule, private equity firms will own 70–90% of the common equity of the bought-out firm, with the rest held by management and former shareholders. Another potential source of financing for leveraged buyouts is preferred equity. Preferred equity is often attractive, given that its dividend interest payments represent a minimum return on investment while its equity ownership component allows holders to become participants in any equity upside. Preferred interest is often structured as pay-in-kind (PIK) dividends, meaning that any interest is paid in the form of additional shares of preferred stock.

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48 Source: Jonathan Olsen (2002). ‘Note on Leveraged Buyout’. Tuck School of Business at Dartmouth Note.

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Figure 5.2 How a Typical Buyout is Financed

Equity 30% Bank Loans 45%

High Yield Bonds 25% Source: Service Employees International. ‘Union Behind the Buyout’. April 2007 Report

LBO firms will often structure their equity investment in the form of preferred stock, with management and employees receiving common stock.

A Look behind Two Large Buyout Deals Excerpted from ‘Behind the Buyouts’, a report prepared by the Service Employees International Union (an American-based labour union), and reproduced with kind permission.

The Bain Buyout of KB Toys In December 2000, at the height of the busy Christmas shopping season, Bain Capital purchased KB Toys in a highly leveraged buyout worth $300 million.49 Bain invested only $18.1 million of its own money and financed the rest with bank loans and other assorted IOUs.50 The early 2000s were a tough time for toy retailers, and competition was fierce from bulk discount sellers like Wal-Mart and Target.51 Yet in April of 2002, KB Toys’ new owners implemented a dividend recap – a second mortgage of sorts – to pay Bain and several KB Toys executives a special dividend of $120 million.52 49 Nathan Vardi. ‘Toy Story’. April 18, 2005. Forbes. 50 Ibid. 51 ‘FAO Bankrupt Again’, ConsumerAffairs.com, 3 December, 2003. Available from http://consumeraffairs.com/. 52 Joan Verdon. ‘New game in town; KB Toys remodels to lure mall shoppers’. 26 August, 2006. The Record.

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KB Toys’ employees and creditors, on the other hand, were about to face some serious financial challenges. In January 2004, KB Toys filed for bankruptcy protection. The new year started off with announcements that at least 30% of stores would close and nearly a third of the workforce would lose their jobs.53 Employees, creditors and the communities that KB Toys served waited to learn where the cuts would take place.54 In the end, nearly 600 stores closed and 4,000 employees received pink slips.55 Big Lots, from whom Bain had purchased KB Toys, had to reveal to its shareholders that not only had it not received payment on the $45 million note, but that it was also left holding the bag on store leases that KB Toys defaulted on as it closed stores nationwide. As of the close of 2006, some landlords were still waiting for payment of old rents.56 In an action to recover the note and other damages, Big Lots alleged that Bain Capital’s 2002 dividend recap led to the company’s bankruptcy, characterising the practice as an ‘unjustified return on [their] investment in excess of . . . 900% in a mere 16 months’.57 Bain Capital and KB Toys’ executives cited the difficulty of competing with the discount stores as the cause of the company’s woes.58 The Delaware state court dismissed Big Lots’ case, finding that Big Lots was limited to bankruptcy proceedings to enforce this claim. KB Toys emerged from bankruptcy in 2005 when a new owner – another private equity firm – invested $20 million.59 For the 4,000 former KB Toys’ employees who lost their jobs, it was a harsh lesson in the game of private equity buyouts.60

The Carlyle/Calyton Dubilier & Rice Buyout of Hertz Car Rental Potential investors are told that one of the strengths of private equity investments is that they are not beholden to the tyranny of short-term returns like the public markets. ‘Private equity firms are not under public scrutiny . . . so

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53 ‘KB Toys to Close Stores and Cut Jobs’, The New York Times, 29 January, 2004. 54 ‘Big Lots weighs fallout of KB Toys’ bankruptcy filing’, Business First of Columbus, 20 January, 2004; ‘KB Toys to remain player for local shoppers’, Business First of Louisville, 28 January, 2005. 55 Google Finance KB Toys Profile, http://finance google.com/finance?cid=6026019, viewed 7 April, 2007. 56 Big Lots stated a cost of $1.6 million net of tax for these leases in its 10-K report filed with the SEC on 2/3/2007. 57 Big Lots Stores Inc., Plaintiff v. Bain Capital fund VII, LLC, C.A. No. 1081-N Court of Chancery Delaware. 58 Residual Trust of KB Toys v. Bain Capital LLC et al. filed in Suffolk Superior Court, 13 January, 2006. 59 Joan Verdon. ‘New game in town; KB Toys remodels to lure mall shoppers’. 26 August, 2006. The Record. 60 Nathan Vardi. ‘Toy Story’. 18 April, 2005. Forbes.

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they can focus on long-term business growth’, they are told.61 And so when a consortium of private equity firms, including industry giant the Carlyle Group, Clayton, Dubilier & Rice (CD&R), and Merrill Lynch, bought Hertz, the car rental company, from the Ford Motor Company in the autumn of 2005 for $15 billion, it was expected that they would formulate a long-term plan to build on the value of this household brand name.62 But the firms had some short-term plans as well. Carlyle partner and fellow buyout firm CD&R realised that they could ‘push the boundaries of how much a rental fleet could be securitised by many billions of dollars’.63 By leveraging the company’s key asset with an eye on ‘flipping’ or selling the company for a profit, the firms jeopardised the company’s credit rating: Standard & Poor’s downgraded the company’s bonds to junk status.64 Just six months after the deal was finalised, the new owners had Hertz take out another loan for nearly $1 billion in order to pay themselves a special dividend.65 A few weeks later – less than a year after buying out the company from Ford – Hertz announced that it would once again be going public.66 In its IPO filing, Hertz stated that money from the public offering would be used to pay off the loan for the special dividends.67 The November IPO raised $1.3 billion, while the buyout group continued to own more than 70% of Hertz.68 The buyout firms used most of what was left after paying off Hertz’s $1 billion loan to pay themselves another $260 million in special dividends.69 ‘Fast-buck artists’ is the name that Business Week gave to the buyout consortium in their report on the Hertz IPO.70 But while the buyout firms were 61 171 ‘Special Supplement: Private Equity – Long-term leverage’. Pensions Week (13 February, 2006). 62 ‘Ford to sell the Hertz Corporation to Private Equity Group in $15 billion transaction’. Ford Motor Company press release, 12 September, 2005. Available from http://media.ford.com/newsroom/release_display.cfm?release=21555. 63 Rik Kirkland, ‘Private Money’, Fortune Magazine, 5 March, 2007. Available from http://money.cnn.com/magazines/fortune/fortune_archive/2007/03/05/ 8401262/index.htm. 64 ‘Buyout firms hurt bondholders by gorging on dividends’, Bloomberg News, 1 November, 2006 (http://www.bloomberg.com/apps/news?pid=206011 03& sid=aoXPtWaqugCc&refer=us); ‘Buy It, Strip It, Then Flip It’, Business Week, 7 August, 2006. Available from http://www.businessweek.com/investing/insights/ blog/archives/2006/07/phew_hertz_didn.html. 65 Hertz Global Holdings, 10-K, filed with SEC, 30 March, 2007; Lynn Cowan, ‘Hertz Plans IPO of 28% Stake to Finance Dividends to Owners’, The Wall Street Journal, 28 October, 2006. 66 ‘Hertz Global Holdings, Inc. announces the filing of a Registration Statement for the Initial Public Offering of Its Common Stock’, Hertz Press Release, 14 July, 2006. 67 Hertz Global Holdings, S-1, filed with SEC, 14 July, 2006, p. 39. 68 Hertz Global Holdings, 10-K, filed with SEC, 30 March, 2007; see p. 55.for the amount raised; see p. 1 for the amount of equity retained by the buyout firms. 69 Ibid. 70 ‘Buy It, Strip It, Then Flip It’, Business Week, 7 August, 2006.

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paying themselves special dividends, profits at the company fell sharply due to the increased debt. For 2006, Hertz reported an increase in revenue of nearly 8% but a decline in net income of two-thirds due to an 80% increase in total interest payments.71 And what became of Hertz’s employees? Just a few days into 2007, Hertz announced it would be cutting jobs as part of its ‘productivity and efficiency’ initiative.72 Altogether, in the first two months of 2007, Hertz announced that it was eliminating 1,550 jobs, which represented close to 5% of the 31,500 workers Hertz employed at the end of 2006.73 In March 2007, CEO Mark Frissora added that only one of every two workers who left the company was being replaced and that Hertz would be announcing more ‘layering and restructuring’ initiatives later that year.74

Brief Explanation of a Dividend Recapitalisation and its Risks In a dividend ‘recap’, private equity investors take out new debt on a company and then use all or part of this additional cash to pay themselves a special dividend. Thus, the dividend comes from debt and not from earnings, and the debt is used at least partially for a payout rather than investing in the company to increase its value. According to Standard & Poor’s, the volume of dividend recaps increased from $3.9 billion in 2002 to $40.5 billion in 2005, with the volume for the first six months of 2006 up an additional 23% over the equivalent period in 2005. In a survey of 75 private equity firms with funds of $500 million or more, 97% of respondents stated that they planned to use recaps in portfolio companies in 2007 and 75% expected to increase their usage. The benefits a recap provides to the private equity firm include a quick return of funds to limited partners, thus increasing its internal rate of return, and the ability to cash out equity without selling the company or offering an IPO. However, by adding debt to already highly leveraged companies, the dividend recap increases a company’s vulnerability to potential operational fluctuations or external changes that could result in either bankruptcy or restructuring.75

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71 Hertz Global Holdings, 10-K, filed with SEC, pp. 21–22. 72 ‘Hertz Announces First Phase of Productivity and Efficiency Initiatives’, Hertz Press Release, 5 January, 2007. 73 Hertz Global Holdings, 10-K, filed with SEC, pp. 21–22. 74 Hertz Fourth Quarter 2006 Earnings Conference Call, 13 March, 2007; transcript by Thomson Street Events. 75 Ibid.

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Venture Capital This chapter provides an overview of venture capital, including a list of notable venture capital firms.

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Introduction Venture capital (also known as VC or venture) is a type of private equity capital typically provided to early-stage, high potential growth companies in the hope of generating a return through an eventual realisation event, such as an IPO or trade sale of the company. Venture capital investments are generally made as cash in exchange for shares in the invested company and are seen as relatively high risk because they are unsecured. Please note that in Europe, but not in the USA, some commentators use the term ‘venture capital’ to cover all stages, i.e. as synonymous with ‘private equity’. In the USA, ‘venture capital’ refers only to investments in early-stage and expanding companies. Venture capital typically comes from institutional investors and high networth individuals and is pooled together by dedicated investment firms. It is most attractive for new companies with a limited operating history that are too small to raise capital in the public markets, can’t get an injection of further capital from the current owner and are too immature to secure a bank loan or complete a debt offering. In exchange for the high risk that venture capitalists assume by investing in smaller and less mature companies, they usually get significant control over company decisions, in addition to a significant portion of the company’s ownership (and consequently value). The venture capital firm will therefore be looking for a high return (perhaps a compound return of 25% or more), largely generated by growth in the capital value of the business. Figure 6.1 US Venture Capital Investments by Year Year

Number of deals

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

2,469 3,080 3,550 5,396 7,812 4,451 3,053 2,876 2,991 3,027

Total Investment (USD millions) 10,762.30 14,591.99 20,718.89 53,487.98 104,379.88 40,537.78 21,692.88 19,613.81 21,768.86 22,261.59

Source: http://www.nvca.org/ffax.html

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Venture capital money is commonly used in conjunction with a management buyout (MBO) or buy-in (MBI), where the management team are themselves investing in the business and so demonstrating their commitment to its success.

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Venture Capital

Professionally managed venture capital firms are, in general, private partnerships or closely held corporations funded by private and public pension funds, endowment funds, foundations, corporations, wealthy individuals, foreign investors and the venture capitalists themselves. Venture capitalists, in general, engage in the following activities: Providing finance to new and rapidly growing companies; Purchasing equity securities; Providing assistance in the development of new products or services; Actively participating in the running of a company with a view to adding value to the company; ■ Taking higher risks with the expectation of higher rewards. ■ ■ ■ ■

When considering an investment, venture capitalists, with their longterm orientation, carefully screen the technical and business merits of the proposed company. Venture capitalists only invest in a small percentage of the businesses they review and have a long-term perspective. Going forward, they actively work with the company’s management by contributing their experience and business knowledge gained from helping other companies with similar growth challenges. Venture capitalists lessen the risk of venture investing by developing a portfolio of young companies in a single venture fund. Time and again they will co-invest with other professional venture capital firms. Additionally, many venture partnerships will manage multiple funds simultaneously. For decades, venture capitalists have fostered the growth of America’s high technology and entrepreneurial communities, resulting in significant job creation, economic growth and international competitiveness. Companies such as the Digital Equipment Corporation, Apple, Federal Express, Compaq, Sun Micro­ systems, Intel, Microsoft and Genentech are famous examples of companies that received venture capital early in their development.

Definitions of Venture Capital Venture capital is money provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant economic contributors. Venture capital is an important source of equity for start-up companies. (National Venture Capital ­Association) Venture capital is a fund made available for start-up firms and small businesses with exceptional growth potential. Managerial and technical expertise is often also provided, also called risk capital. (Investorwords.com) Venture capital is equity or equity-featured capital seeking investment in new ideas, new companies, new production methods, new processes or new services that offer the potential of high returns on investments. (International Finance Corporation)

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A venture capital fund means a fund established in the form of a company or trust which raises monies through loans, donations, the issue of securities or units as the case may be, and makes or proposes to make investments in accordance with these regulations. (Regulation 2(m) of SEBI (Venture Capital Funds) Regulation)

Venture Capital Investing Venture capital investing has experienced tremendous growth from a small investment pool in the 1960s and early 1970s to a mainstream asset class that is a viable and major part of the institutional and corporate investment port­ folio. In recent times, some investors have been referring to venture investing and buyout investing as ‘private equity investing’. There could be some confusion surrounding this term, given that some in the investment industry use the term ‘private equity’ to refer only to buyout fund investing. At any rate, an institutional investor will typically allocate 2 to 3% of their institutional port­folio for investment in alternative assets such as private equity or venture capital as part of their overall asset allocation. Currently, over 50% of investments in venture capital/private equity come from institutional public and private pension funds, with the remainder coming from endowments, founda­ tions, insurance companies, banks, individuals and other entities who seek to diversify their portfolio with this investment class.76

What is a Venture Capitalist? The typical layman description of a venture capitalist is that of a wealthy financier who wants to fund start-up companies. The view taken is usually that of a person who develops a brand-new radically innovative invention that needs capital; therefore, if they can’t get capital from a bank or from their own personal resources, they solicit the help of a venture capitalist. In actual fact, venture capital and private equity firms are pools of capital, typically organised as limited partnerships that invest in companies which ­represent the opportunity for a high rate of return, typically within five to seven years. The venture capitalist may examine several hundred investment opportunities prior to investing in only a few selected companies with favourable investment opportunities. Far from being simply passive financiers, venture capitalists promote growth in companies through their involvement in the management, strategic marketing and planning of their investee companies. They are entrepreneurs first and financiers second.

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76 Source: National Venture Capital Association. ‘The Venture Capital Industry – An Overview’, available from www.nvca.org/def.html.

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Individuals may also be classed as venture capitalists. In the early days of venture capital investment, in the 1950s and 1960s, individual investors were the conventional venture investor. Although this type of individual investment did not totally fade away, there was an emergence of the modern venture firm as the foremost venture investment vehicle. Nevertheless, in recent years, individuals have again become a potent and increasingly larger part of the early-stage start-up venture life cycle. These ‘angel investors’ will provide mentoring for a company and offer the required capital and expertise to assist in its development. Angel investors may either be wealthy people with management expertise or retired business men and women who search for the opportunity for first-hand business development.

History of Venture Capital While there are similarities between venture capitalists and some primitive forms of financing, historians believe that the origins of venture capital can be traced back to the years after World War II. In Islamic society in the middle ages, a form of partnership arrangement was practised that closely resembles the current system of venture capital investment. Experts, however, are inclined to claim that the history of venture capital began with the establishment of the American Research and Development Corporation in 1946. AR&DC was founded by General Georges Doriot (‘father of venture capitalism’), at the time a recently retired United States Army General, who was born in France and educated at Harvard. Doriot’s AR&DC is credited with venture capital provided for the startup of the Digital Equipment Corporation. The investment was to the tune of $70,000 in 1957 and it eventually appreciated to the value of $355 million.77 Digital went public in 1968 and by this time AR&DC was enjoying an annual rate of return of 10%. This truly remarkable success story was perhaps the platform on which venture capitalists have built their ultimate business model. In 1958, the US Congress passed the Small Business Investment Act and as a result, the Small Business Administration got involved with the venture capitalist concept. The Act enabled small business investment companies (SBICs) to be licensed. Before World War II, it was mainly the eccentric rich or supportive families that provided venture capital for projects that were technologically ground-breaking. Given the reluctance of traditional lending institutions, such as banks, to finance such risky ventures, the US Congress realised the need to encourage and facilitate the flow of investment capital into these areas to foster economic growth and maintain the country’s competitive edge in terms of technology. 77 Source: Venture Capital Investment Firms. ‘The History of Venture Capital’. Available from www.vesturecapitalinvestmentfirms.com/history-venture-capital as accessed on 04/02/09.

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The advent of the information and technological revolution of the latter part of the 20th century provided a solid avenue for venture capital to grow. The rise of Silicon Valley in California turned San Francisco into a centre for venture capital investment. The venture capital industry had been exceptionally sensitive to stock-market activity due to the fact that their investments are typically in the form of stock ownership. The downturn of the stock market in 1974 was a major setback for venture capital firms. The dot-com boom in the latter part of the 1990s followed by the NASDAQ and technological bust of the early 2000s was another topsy-turvy period for venture capitalists.

Venture Capital Firms and Funds Venture capital firms are typically structured in the same way as private equity firms, described elsewhere in this book. Figure 6.2, which is self-explanatory, provides an illustration of the structure of a generic venture capital fund. Figure 6.2 Diagram of the Structure of a Generic Venture Capital Fund

Venture Capital Firm (General Partner)

Limited Partners (Investors) (public pension funds, corporate pension funds, insurance companies, high net-worth individuals, family offices, endowments, foundations, fund-of-funds, sovereign wealth funds, etc.)

Ownership of the Fund Fund Investment Management

Venture Capital Fund (Limited Partnership) The Fund’s ownership of the portfolio investments

Investment

Investment

Investment

Source: Venture Capital on Wikipedia as accessed on 03/02/09

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‘Venture capitalists’ or ‘VCs’ is the title given to general partners and other investment professionals of the typical venture capital firm. While their career backgrounds may differ, venture capitalists are usually from either operational

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Venture Capital

or finance backgrounds. Those with an operational background tend to be former founders or executives of companies akin to those which the partnership finances or would have served as management consultants, while those with finance backgrounds are usually equipped with investment banking or other corporate finance experience. Please note that the titles are not entirely uniform from firm to firm; other positions at venture capital firms include: ■ Venture partners – Their key roles are to source potential investment opportunities (‘bring in deals’ as they say in the industry) and usually are remunerated only for those deals with which they are involved. ■ Entrepreneur-in-residence (EIR) – These are experts in a specific domain and undertake due diligence on potential deals. EIRs are hired by venture capital firms temporarily (6 to 18 months) in the expectation that they will be able to develop and pitch start-up ideas to their host firm (although neither party is bound to work with each other). Some EIRs progress to executive positions within a portfolio company. ■ Principal – This is a mid-level investment professional position, and in some firms principals are fast-tracked to partners. Principals will typically have been promoted from a senior associate position or have commensurate experience in another field, such as investment banking or management consulting. ■ Associate – This is typically the most junior apprentice-type position within a venture capital firm. After a few successful years, an associate may be elevated to the ‘senior associate’ position and potentially principal and higher. Associates will often have 1–2 years experience in another field, such as investment banking or management consulting.

Investment Focus Venture capitalists may assume the role of generalist or specialist investors, according to their investment strategy. Venture capitalists that are generalists invest in a variety of industry sectors, or different geographic locations, or various stages of a company’s life. Then again, they may be specialists in one or two industry sectors, or may look to invest in only a localised geographic area. Not all venture capitalists invest in ‘start-ups’. Although venture firms will invest in companies that are in their initial start-up forms, they will also commit to investment in companies at various stages of the business life cycle. A venture capitalist may start investing before there is a tangible product or company organised (so-called ‘seed investing’), or may provide the necessary funds to start up a company in its first or second stages of development, referred to as ‘early-stage investing’. In addition, the venture capitalist may provide the required financing to assist a company in its growth beyond a critical mass to achieve a more successful exit (‘expansion-stage financing’).

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The venture capitalist may invest in a company throughout the company’s life cycle and therefore some funds focus on ‘later-stage’ investing by providing the required finance to help the company grow to a critical mass to attract public financing through a stock offering. On the other hand, the venture capitalist may help the company attract a merger or acquisition with another company by providing liquidity and exit for the company’s founders. At the other end of the spectrum, some venture funds’ area of specialisation is the acquisition, turnaround or recapitalisation of public and private companies that characterise favourable investment opportunities. There are venture funds that will be broadly diversified and typically invest in companies in industry sectors as varied as semiconductors, software, retailing and restaurants and others that may be specialists in only one technology. Although high technology investment constitutes most of the venture investing in a country like the USA, and the spotlight is on the venture ­industry’s high technology investments, venture capitalists also invest in companies such as construction, industrial products, business services etc. There are quite a lot of firms that have specialised in retail company investment and others that have focused on investing only in ‘socially responsible’ start-up endeavours. There are different sizes of venture firms ranging from small seed specialist firms with only a few million dollars under management to firms with over a billion dollars of invested capital worldwide. What all these firms have in common is the active role that the venture capitalist plays and the vested interest they have in the guiding, leading and growing of the companies they have invested in. They aim to add value through their experience in investing in tens and hundreds of companies. A number of venture firms have the skills for creating synergies between the various companies they have invested in; for instance one company that has a marketable electronic product, but does not have sufficient distribution technology, may be matched with another company or its management in the venture portfolio that has better distribution technology.

Length of Investment Venture capitalists assist the growth of companies, but they are ultimately looking to exit the investment in three to seven years. While an early-stage investment may take seven to ten years to mature, a later-stage investment may only take a few years, so the appetite for the investment life cycle must be aligned with the limited partnerships’ appetite for liquidity. The nature of venture investment is such that it is neither a short-term nor a liquid investment, but an investment that must be committed to with careful diligence and expertise.

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Venture Capital

Types of Firms There are several types of venture capital firms. However, most mainstream firms invest their capital through funds organised as limited partnerships, in which the venture capital firm serves as the general partner. The following are types of venture capital firms: ■ Private independent firm – This is the most common type of venture firm and is an independent venture firm that has no affiliations with any other financial institution. ■ Affiliate or subsidiary of a commercial bank, investment bank or insurance company – This type of firm makes investments on behalf of outside investors or the parent firm’s clients. ■ Corporate venture investor –Also known as a ‘direct investor’, this is typically a subsidiary of a non-financial, industrial corporation that makes investments on behalf of the parent itself. ■ Government affiliated investment programme – This helps startup companies through government-sponsored programmes in some countries. Just like private equity firms, the venture capital firm normally organises its partnership as a pooled fund, i.e. a fund made up of the general partner and the investors or limited partners. These funds are usually organised as fixedlife partnerships, normally with a life of ten years. Each fund is capitalised by commitments of capital from the limited partners. Once the partnership has attained its target size, the partnership is closed to further investment from new investors or even existing investors in order that the fund has a fixed capital pool from which to make its investments.

Corporate Venturing This form of investing was popular in the 1980s and has become very popular in recent times. Corporate venturing is usually called ‘direct investing’ in portfolio companies by venture capital programmes or subsidiaries of nonfinancial corporations. These investment vehicles aim to seek out qualified investment opportunities that are aligned with the parent company’s strategic technology or that offer some sort of synergy or cost savings. These corporate venturing programmes may be loosely organised programmes that have affiliations with existing business development programmes or may be self-contained entities that have a strategic charter and mission to invest in a way that is harmonious with the parent’s strategic ­mission. There are a number of venture firms that focus on advising, consulting and managing a corporation’s venturing programme. The main difference between corporate venturing and other types of venture investment vehicle is that corporate venturing is usually undertaken with a consideration for corporate strategic objectives whereas other venture

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investment vehicles usually have investment returns or financial objectives as their main purpose. The other distinguishing aspect of corporate venture programmes is that they normally invest their parent’s capital, while other venture investment vehicles invest outside investors’ capital.

Commitments and Fund-raising The process that venture firms go through in seeking investment commitments from investors is similar to private equity firms and is also called ‘fund-raising’. Please note that this should not be confused with the actual investment in investee or ‘portfolio’ companies by the venture capital firms, which is also sometimes called ‘fund-raising’ in some circles. The commitments of capital are raised from the investors during the formation of the fund. A venture firm will begin prospecting for investors with a target fund size. It will normally distribute a prospectus to potential investors and may take from several weeks to several months to raise the requisite capital. The fund will seek commitments of capital from the usual sources: institutional investors, endowments, foundations etc.

Capital Calls Capital calls are the required investment capital commitments that a venture firm collects or ‘calls’ from its limited partners, often in a series of tranches. These capital calls from the limited partners to the venture fund are sometimes called ‘takedowns’ or ‘paid-in’ capital. Not so long ago, the venture firm would ‘call’ this capital down in three equal instalments over a three-year period. However, in more recent times, venture firms have synchronised their funding cycles and call their capital on an as-needed basis for investment.

Illiquidity Limited partners make these investments in venture funds in the knowledge that the investment will be a long-term commitment. It often takes several years before they start to make a return on their investments; in many instances the invested capital may be tied up in an investment for seven to ten years. Limited partners have an understanding of this illiquidity and usually factor it into their investment decision.

Other Types of Funds

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Given that venture firms are private firms, there is usually no way to exit before the partnership totally matures or expires. In recent years, a new form of venture firm has evolved: so-called ‘secondary’ partnerships that specialise in purchasing the portfolios of investee company investments of an existing venture firm. This type of partnership provides some liquidity for the original

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investors. These secondary partnerships, expecting a large return, invest in what they consider to be undervalued companies.78

Advisers and Fund of Funds Evaluating which funds to invest in is similar to choosing a good stock manager, except the decision to invest is a long-term commitment. This investment decision requires considerable investment knowledge and time on the part of the limited partner investor. The larger institutions have investments in excess of 100 different venture capital and buyout funds and continually invest in new funds as they are formed. Some limited partner investors may have neither the resources nor the expertise to manage and invest in many funds and thus may look to delegate this decision to an investment adviser or so-called ‘gatekeeper’. This adviser will pool the assets of its various clients and invest these proceeds as a limited partner into a venture or buyout fund in the process of raising capital. On the other hand, an investor may invest in a ‘fund of funds’ (see Chapter 7), which is essentially a partnership organised to invest in other partnerships, therefore providing the limited partner investor with additional diversification and the capability to invest smaller amounts into a variety of funds.

Disbursements The investments by venture funds into investee portfolio companies are known as ‘disbursements’. A company will receive injections of capital in one or more rounds of financing. A venture firm may make these disbursements on its own, or in many instances will co-invest in a company with other venture firms (‘co-investment’ or ‘syndication’). This syndication provides more capital resources for the investee company. Firms co-invest because the company investment is aligned with the investment strategies of various venture firms and each firm will offer some competitive advantage to the investment. Like other private equity firms, the venture firm will provide capital and management expertise and will typically also take a seat on the board of the company to make sure that the investment has the best chance of being successful. A portfolio company may receive one round, or in many cases, several rounds of venture financing in its life as required. A venture firm may not invest all of its committed capital, but will retain some capital as a reserve for future investments in a number of its successful companies with additional capital requirements.

78 Source: National Venture Capital Association. ‘The Venture Capital Industry – An Overview’, available from www.nvca.org/def.html.

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Exits In most cases, the venture firm will look to exit the investment in the portfolio company within three to five years of the initial investment, depending on the investment focus and strategy of the venture firm. Although the initial public offering may be the most high-profile and publicised type of exit for the venture capitalist and owners of the company, most successful exits of venture investments happen through a merger or acquisition of the company by either the original founders or another company. Then again, the expertise of the venture firm in successfully exiting its investment will dictate the ­success of the exit for themselves and the owner of the company.

IPO The initial public offering is the most high-profile and noticeable type of exit for a venture investment. In recent years, technology IPOs have been renowned during the IPO boom of the early part of this decade. At a public offering, the venture firm is considered an insider and will receive stock in the company, but the firm is regulated and restricted in how that stock can be sold or liquidated for several years. Once this stock is freely tradable, usually after about two years, the venture fund will distribute this stock or cash to its limited partner investors who may then manage the public stock as a regular stock holding or may liquidate it upon receipt.79 Over the last two decades, almost 3,000 companies financed by venture funds have gone public.

Mergers and Acquisitions Mergers and acquisitions are known as the most common type of successful exit for venture investments. With a merger or acquisition, the venture firm will receive stock or cash from the acquiring company and the venture investor will distribute the proceeds from the sale to its limited partners.

Valuations Just like a mutual fund, each venture fund has a net asset value or the value of an investor’s holdings in that fund at any given time. But, unlike a mutual fund, this value is determined through a valuation of the underlying portfolio as opposed to through a public market transaction. It is worth recalling that the investment is illiquid and at any point, the partnership may have both private companies and the stock of public com­ panies in its portfolio. These public stocks are usually subject to restrictions for a holding period and are thus subject to a liquidity discount in the portfolio valuation.

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79 Source: National Venture Capital Association. ‘The Venture Capital Industry – An Overview’, available from www.nvca.org/def.html.

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Each company is valued at an agreed-upon value between the venture firms when invested in by the venture fund or funds. In subsequent quarters, the venture investor will usually keep this valuation intact until such a time that a material event happens to change the value. Venture investors attempt to conservatively value their investments using guidelines or standard industry practices and by terms outlined in the prospectus of the fund. The venture investor is usually conservative in the valuation of companies, but it is ­common to find that early-stage funds may have an even more conservative valuation of their companies as a result of the long lives of their investments when compared to other funds with shorter investment cycles.

Management Fees As an investment manager, the general partner will typically charge a ­management fee to cover the costs of managing the committed capital. The management fee will usually be paid quarterly for the life of the fund or it may be tapered or curtailed in the later stages of a fund’s life. This is most often negotiated with investors upon formation of the fund in the terms and conditions of the investment.

Carried interest As in private equity firms, ‘carried interest’ is the term used to indicate the profit split of proceeds to the general partner. This is essentially the general partner’s fee for carrying the management responsibility plus all the liability and for providing the needed expertise to successfully manage the investment. There are as many variations of this profit split, both in the size and how it is calculated and accrued, as there are firms.

Differences between VCs and Banks Some of the differences between venture capital firms and banks or other firms that offer conventional financing are listed in the table below.

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Venture Capital Firm

Banks

VC financing invests in the equity of the Conventional financing generally company. extends loans to companies. VC financing returns are by way of capital appreciation.

Conventional financing looks to current income, i.e. dividend and interest.

VC financing is risk-taking finance, where potential returns outweigh risk factors.

Assessment in conventional financing is conservative, i.e. lower the risk, higher the chances of getting loan.

VC is not a lender but an equity partner. A bank or an FI will fund a project as long as it is sure that enough cash flow will be generated to repay the loans.

Venture Capital Funding Venture capitalists are usually quite fussy when deciding on the types of investment they want to undertake; in general, a fund may invest in 1 in 500 opportunities that it is presented with. Funds are attracted to ventures with extremely high growth potential, as only opportunities such as these are likely to be capable of providing the financial returns and successful exit event within the required time frame (usually 3 to 7 years) that venture capitalists desire. Given that investments are illiquid and require a timescale of about 3 to 7 years to harvest, venture capitalists are expected to conduct thorough due diligence prior to investment. Venture capitalists are also expected to foster the companies in which they invest, so as to increase the likelihood of reaching an IPO stage when valuations are favourable. Venture capitalists usually assist at four stages in the company’s development.80 ■ ■ ■ ■

Idea generation; Start-up; Ramp up; and Exit

There are typically six stages of financing provided by venture capital firms, which approximately correspond to these stages of a company’s development:81 1. Seed money – This can be described as low-level financing needed to prove a new idea (often provided by ‘angel investors’). 2. Start-up – This is for early-stage firms that require funding for expenses associated with marketing and product development.

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80 Ibid. 81 Westerfield, Jaffe et al. (2008). Corporate Finance. McGraw-Hill publishing.

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3. First round – This is used for early sales and manufacturing funds. 4. Second round – This is working capital for early-stage companies that are selling a product, but not yet turning a profit. 5. Third round – Also called mezzanine financing, this is expansion money for a newly profitable company. 6. Fourth round – This is also referred to as bridge financing; the aim is to use fourth round to finance the ‘going public’ process. Given that their securities are not listed on any exchanges, private companies meet venture capital firms and other private equity investors in various ways, including conferences and symposia; warm referrals from the investors’ trusted sources and other business contacts; and summits, where companies pitch directly to investor groups in face-to-face meetings, including a variant known as ‘speed venturing’. This is akin to speed-dating for capital, where the investor decides within 10 minutes whether they want a follow-up meeting. The programme Dragons’ Den, aired on a number of television stations around the world, also exemplifies the meeting point for venture capital investors and their potential investee companies. Venture funding is an expensive capital source for companies, given the requirement for high returns, and is appropriate for businesses having large up-front capital needs which cannot be financed by less expensive alternatives such as debt. That is most usually the case for intangible assets such as software and other intellectual property whose value is unproven. In turn, this provides an explanation as to why venture capital is most prevalent in the fast-growing technology and life sciences or biotechnology fields (this is discussed later in the chapter). A company with the following qualities: 1) a solid business plan, 2) a good management team, investment and passion from the founders, 3) a good potential to exit the investment before the end of their funding cycle, 4) a target minimum return in excess of 40% per year, will be an appropriate ­candidate for venture capital funding.

Sectors within which Venture Operates Venture capital-backed companies can make a substantial contribution to the development of a successful knowledge-based economy. Venture capital is a very efficient means of stimulating innovation. It is three times more effective than corporate R&D and so is a key component of any innovation-friendly environment.82 IT, telecoms and life sciences, to be discussed below, fall into the category of industries that foster innovation.

82 Library House. ‘Venture Capital Innovation – Driving Forward the KnowledgeBased Economy’. June 2007 Report.

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IT The US venture capital industry has become an important source of capital for technology start-ups around the world. In 2006, for instance, E11 billion was invested in American IT companies compared with E1.8 billion that was invested in European IT companies. In spite of this, IT is regarded as the most important target sector for venture capitalists in Europe and is a key driver of innovation. India and China are also growing in prominence with regard to venture capital investment in IT. One of the drivers for growth in the venture capital industry in IT is the realisation that the time has come to move beyond the debate about whether IT makes a positive contribution to economic growth and focus on how to maximise this positive effect. The ‘computer productivity paradox’ has been answered by the USA’s dramatic productivity surge in the late 1990s. Figure 6.3 Investment Trends within the IT sector – Total institutional deal values by Quarter IT Hardware IT Software

IT Services IT Systems

Institutional deal values (E000s)

300,000 250,000 200,000 150,000 100,000 50,000 0

2006 Q1

2006 Q2

2006 Q3

2006 Q4

Source: Library House

Within the IT sector, venture capital is a good proxy for innovation because venture capitalists back companies they believe to have dramatic forward growth potential. These are often the companies with the most innovative and viable technologies and ideas. In addition, academic research has demonstrated that venture capital is one of the most efficient ways of funding innovation.83

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83 Source: European Commission. (2002). ‘Life Sciences and Biotechnology – A Strategy for Europe’.

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Technology deals in the venture capital industry were traditionally divided into computer hardware and software. Experts, though, believe that it is increasingly difficult to differentiate between IT and telecoms deals. Industry reports show that in recent times the software subsector of IT attracted the largest amount of venture capital funding. The hardware subsector, on the other hand, appears to be decreasing, given that hardware companies require considerably more investment than software companies. However, experts believe that on the whole, IT hardware companies generate higher revenues on average when compared to other IT companies and they also need significantly more capital (see Figure 6.4 as an illustration). Figure 6.4 Average Capital invested versus Average Revenues generated by European Venture-backed IT Companies 30,000

IT hardware rev/inv = 0.17

Mean invested (E000s)

25,000

♦

20,000 IT software rev/inv= 0.24

15,000 IT systems rev/inv = 0.08

10,000

♦♦

♦

IT services rev/inv = 0.28

5,000 0 0

2,000

4,000

6,000

Mean revenue (E000s) Source: Library House

Experts also claim that they have noticed a trend whereby a greater proportion of deals invested in software, services and systems were first round when compared with hardware. One could argue that investors looking for new opportunities are perhaps increasingly focusing on software, services and systems, possibly for the reasons discussed above. On the other hand, the greater need for capital in IT hardware may imply that many more institutional investment rounds are needed prior to exit in this subsector than the others. A number of industry experts assert that a major consideration for potential investors in IT is the practicality of potential exit routes. Observers also

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claim that a larger percentage of IT companies plan to exit through a trade sale than those with a preference for exit via an IPO.

Telecoms Experts unanimously agree that the telecoms industry has perhaps been the most thrilling sector in recent times. Some major developments have led them to this conclusion and these include: ■ The rapid growth of the internet; ■ The wider adoption of the internet as a result of the relentless increase in speed of affordable broadband; ■ Analogue communication being replaced by digital; ■ Email replacing fax; ■ The introduction of fibre-optic cabling; ■ Data communication overtaking voice conversations on both national and international networks; ■ The technological advancement in the mobile telephony universe (3G, UMTS, GPRS etc.). These developments have created countless opportunities for both savvy entrepreneurs and the venture capital community. Wireless and related technology, including networking, infrastructure, semiconductors, mobile computing, content and services, have been receiving increased venture capital funding in recent years. For instance, in 2005, 152 wireless-related companies received $1.3 billion in funding, a 24% increase over 2004’s $1.1 billion.84 Venture capitalists have been turning their attention to markets outside the traditional US and European markets, the rapidly growing global wireless market. In the longer term, the movement towards financing wireless start-ups worldwide will step up, as major funds are allocating funds for start-ups in Asian countries and other regions, each featuring their own disparate dynamics.

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84 Visiongain. (2006). ‘Venture Capital in Wireless and Telecoms: Funding Technology Innovation’. Industry Report.

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Life Sciences and Biotechnology Life sciences and biotechnology offer opportunities to tackle several of the global needs associated with health, ageing, food and the environment, and sustainable development. Life sciences and biotechnology are commonly viewed as two of the most promising frontier technologies in the near future. They are enabling technologies – like information technology, they may be applied for a wide range of purposes for private and public benefits. On the basis of scientific breakthroughs in recent years, the explosion in the knowledge of living systems is set to deliver a continuous stream of new applications.85 The life sciences revolution was born in, and is fed and nurtured by, research. Public research laboratories and institutions of higher education are at the core of the science base, interacting also with enterprise-based research and that of other private bodies.86 The success of any knowledge-based economy rests upon the generation, diffusion and application of new knowledge. Investments in research and development, education and training, and new managerial approaches are therefore of key importance in meeting the challenges posed by life sciences and biotechnology.87 Venture capital investment in life sciences (biotechnology and medical device industries, together) has shown promise of huge growth from 2006 when, according to the MoneyTree Report by PricewaterhouseCoopers and the National Venture Capital Association, in the USA it was the number one investment sector for the year and accounted for 28% of all venture capital invested, consistent with historical percentages.88 In the first quarter of 2007, venture capital investors put $2.9 billion into private US healthcare companies, including $1.8 billion in biopharmaceuticals and $953 million in medical device ventures.89 It is, however, worth noting that development times for life sciences and biotechnology firms are exceptionally lengthy, with eight years on average from first investment to any commercial returns.90

85 Source: European Commission. (2002) ‘Life Sciences and Biotechnology – A Strategy for Europe’. 86 Ibid. 87 Ibid. 88 PricewaterhouseCoopers and the National Venture Capital Association. ‘The 2006 MoneyTree Report’. 89 Robert Dellenbach. (2007). ‘VC Funding Trends for Life Science Firms’. 90 National Venture Capital Association. (2007). ‘Cleantech Venture Investments by US Firms Break Records in 2007’. Available from www.nvca.org/pdf/ CleanTechInterimPR.pdf as accessed on 04/12/08.

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List of Notable Firms91

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Name

Location

Specialty

Atlas Ventures

USA

Technology and life sciences

Azione Capital

Singapore

Interactive digital media, mobile communications, wireless technology, energy, maritime

Benchmark Capital

USA

Technology and financial services

Bessemer Venture Partners

USA, Israel and India

Technology and services

Canaan Partners

USA, Israel and India

Technology and healthcare

Clearstone Venture Partners

USA and India

Internet, consumer, communication software

Draper Fisher Jurvetson USA

Technology and technology services

Enterprise Partners

USA

Technology and life sciences

Fidelity Ventures

USA

Information technology

Highland Capital Partners

USA, Switzerland and China

Consumer, healthcare, info and communications technology, and internet and digital media

Insight Venture Partners

USA

Software and internet

Quicksilver Ventures

USA

Emerging technologies such as video and imaging; networking and mobility; data management, services and security

Sigma Partners

USA

IT: software, hardware, semiconductors

Wellington Partners Venture Capital

Germany

Technology, digital media, life sciences

91 Source: http://en.wikipedia.org/wiki/List_of_venture_capital_firms as accessed on 09/02/09.

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Trends This chapter discusses some of the recent trends in private equity.

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Introduction The private equity industry is a huge force in the global economy. It has evolved from a cottage industry dominated by entrepreneurial individuals into a highly differentiated asset class with its own global institutions. As it moves into the mainstream, private equity has become an established part of the investment mix for many of the world’s largest investors including pension funds, insurance companies, banks and university endowments. These institutions are committing an increasing proportion of their capital to private equity, given that it has outperformed the more established investment choices in the financial markets. On top of offering institutional investors superior returns, available studies reveal that private equity plays an important role in economic growth and job creation. To a certain extent, industry observers believe that private equity has become a victim of its own success. Outstanding performance has drawn ever more assets into the industry and these have been deployed in some of the largest and distinguished companies. That said, the following are some of the recent trends shaping the private equity industry.

Rise of New Industry Players Consortia or ‘clubs’ of private equity firms are the winners of the biggest and most lucrative buyout deals. This is because individual firms often do not have the resources to pursue the opportunities involving larger capital outlays. ‘Club deals’ let the firms share risk and purchase even larger companies.92 A typical example of a private equity transaction, as seen elsewhere, involving a consortium of firms was the acquisition in 2005 of SunGard Data Systems Inc. by a consortium of private equity investment firms, organised by Silver Lake Partners, that also included Bain Capital, The Blackstone Group, Goldman Sachs Capital Partners, Kohlberg Kravis Roberts & Co. L.P., Providence Equity Partners and the Texas Pacific Group.93 Industry executives are of the opinion, however, that in the coming years, the elite private equity firms will be able to raise enough funds to individually fund these more lucrative deals. But until then, these global players have to

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92 Andrew Ross Sorkin, ‘Buyout Firms: Too Close for Comfort?’ International Herald Tribune, 11 October, 2006; David Caruso, ‘Investors sue private equity firms’, Associated Press, 15 November, 2006; David Glovin and Sree Vidya Bhaktavatsalam, ‘KKR, Carlyle, 11 others accused of rigging buyouts’, Bloomberg News, 15 November, 2006. 93 SunGard. ‘Consortium of Private Equity Firms Completes Acquisition of SunGard’. Press Release 11 August, 2005.

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Trends

collaborate with competitors so as to win the most valuable prizes. These collaborations include partnerships with banks as well as hedge funds. In recent years, hedge funds have moved swiftly into private equity, attracted by the sector’s high returns and increasing liquidity, and urged on by the declining returns in their traditional business. Some industry watchers are of the opinion that in the not-too-distant future, hedge funds will become major private equity players in their own right. Others believe this is debatable. The major issue is what they perceive as the lack of patience or post-deal operating skills to add value in the long term to buyout investments. While it is likely that the number of hedge funds that are looking to operate in the space will increase, hedge funds, given their analytical and arbitrage skills, are debatably better suited to bidding for assets than the long, hard toil that ensues. In fact, some private equity executives, though acknowledging that hedge funds could be a competitive threat in the future, are of the opinion that they are potentially advantageous partners for buyout firms in auctions, specifically because they bring this type of expertise into the frame. As for banks, their future role in private equity fundraising and investment is vague. Their ability to compete in LBOs is boosted by the wide range of products they can provide the buyout target, such as debt financing, and their large network of contacts. Many investment banks are still unsure about the viability of in-house private equity divisions. This is because of a potential conflict of interest between different divisions of the bank. It is easy to see the questions that would be brought about by such a decision. What would happen in the event of a bank bidding in an auction against a trade buyer that happened to be one of its ­clients? Also, how would a bank be able to offer its star private equity executives the same level of pay as their contemporaries in the buyout industry, since it needs to take its share of the profits? Then again, the agency and advisory aspects of investment banking are not making a significant contribution to the profitability of the most global players as margins have been thinned out by competition and increasing IT and regulatory costs. The majority of their income streams derive from their own balance sheet. From this standpoint, a profitable private equity division is an important in-house asset because of the sector’s outstanding growth prospects. What traditional private equity firms have to start to think about is whether these new players are potential competitors or allies.

Popularity of Funds of Funds It well known that private equity investing provides investors with a chance to increase returns and lower risks. Based on historical market assumptions, private equity could potentially allow investors to achieve higher returns than

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could be achieved investing in other asset classes. Private equity investing also provides access to a new universe of companies not accessible through the public markets. Besides this, the addition of private equity to a portfolio adds a layer of diversification that may reduce overall risk. Smaller institutional and individual investors often face a challenge in obtaining access to private equity funds. A number of the industry’s most sought-after funds are accessible to investors by invitation only and the high minimum such funds charge means that they are only within reach of the largest institutions and wealthier individuals. There is a high barrier to entry into the private equity space set by the larger and prestigious private equity funds, given that they often can provide their investors with access to the most profitable deals, including buyouts of big companies that are beyond the reach of less capitalised, smaller private equity funds. Yet there are means for smaller institutions and individuals to become participants in the same desirable funds as their better-capitalised contemporaries. One of the most prominent ways is by investing in a fund of funds. These types of fund divide the capital contributed by a number of investors into a select group of private equity funds. The pooling of capital by a fund of funds allows smaller investors to prevail over the higher minimums charged by larger funds. At the same time, the priority deal flows that larger private equity funds offer and the manager talent are still accessible to smaller investors.

Definition of a Private Equity Fund of Funds

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A private equity fund of funds combines capital from many investors and makes commitments to a number of private equity limited partnerships, and at times invests a small portion of the fund in direct co-investments in attractive private companies along with the underlying fund’s general partners to boost returns, adjust allocations and effectively cut fees. A fund of funds is beneficial both for investors with small private equity allocations and for investors with big private equity investment allocations. As the private equity market has grown in recent years, so has the number of fund of funds managers offering an assortment of styles. The styles range from portfolios which cover the total private equity spectrum to niche areas like venture capital or a specific geographic region such as the USA, Europe or Asia. Furthermore, some fund of funds managers combine both methods and have developed a flexible approach which gives investors the alternative of selecting a broad or narrow focus. In a sense, a fund of funds is analogous to a diversified equity portfolio. Instead of having a holding of a single stock or sector/industry group, a fund of funds can offer exposure to many of the private equity asset classes – including venture capital, LBOs, international and so on.

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Benefits of Funds of Funds Most funds of funds offer a variety of benefits, including:

■ Access to elite funds and knowledge of emerging funds that have the potential to achieve top quartile performance; ■ Diversification (e.g. 10–20 underlying funds that may invest in several hundred portfolio companies); ■ Professional fund selection by a permanent team with the essential resources, experience, insight and relationships needed to make informed investment decisions; ■ Lower cost (it is generally less expensive to outsource this specialised service); ■ Higher return expectations with less risk. Given that funds of funds are such well-organised private equity investment vehicles, commitments to funds of funds have increased nearly tenfold to more than $13.9 billion from 1996 to 2005.94 Investors in private equity funds of funds include banks, public and corporate pension plans, insurance companies, endowments/foundations and family offices and high net-worth individuals.

Introduction of Private Equity ETFs One of the most interesting trends in the private equity industry is the introduction of private equity exchange-traded funds (ETF). This type of ETF was introduced to leverage the attractive attributes of private equity as an asset class. Despite the dominance of big investment companies in the private equity space, there is also an opportunity for individuals wanting to acquire stakes in this niche market. Private equity is attractive because privately owned companies do not carry the burden of needing to meet or preferably beat earnings expectations and raise guidance95 in case their stocks get ­battered, and so are in a better position to pursue longer-term strategies. Most of these companies also typically offer better disclosure – those that don’t answer all the questions won’t get the funding they are looking for. The route for individual investors to get involved is provided by publicly traded firms supplying the equity. The key driver for the introduction of private equity ETFs is that most investors have traditionally been excluded from reaping the rewards of private equity deals. The wealthy individuals and deep-pocketed institutions that buy into private equity funds are often required to put up a sizeable amount of money and keep it invested for years on end. 94 Source: Private Equity Fund-of-Funds State of the Market, 2006 Edition. Dow Jones: 2006. 95 This is a document that provides information for investors.

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What are ETFs? ETFs are shares that are traded on a stock exchange and whose assets mirror the price movements of the underlying share portfolio of an index, sector, or commodity. ETFs can replicate a very broad range of indices investing in everything from shares and property, to more recondite asset classes such as private equity. The first widely recognised ETF was created in the early 1990s in the USA and was based on the American S&P 500 index. Estimates from Morgan Stanley show that global ETF assets under management will exceed US$2 trillion by 2011 and at the end of 2007, the global ETF market was worth close to $800 billion.96 ETFs can be used as the building blocks to make it possible to create an investment portfolio. With the increased availability of ETFs, any investor can make use of them for the composition of a portfolio in an efficient and effective manner.

How Does an ETF Work? An ETF is simply a basket of shares that attempts to mirror the performance of a chosen index and trade like a single stock.

ETF versus Investment Trusts ETF

Investment Trust

Trading

Any time during the stockexchange trading day

Any time during the stockexchange trading day

Accessibility

Via a stockbroker

Via a stockbroker

Price vs Net Asset Value

ETFs’ market price tends to trade in line with the NAV of the fund

Typically trade at a discount or premium

Transparency

Daily information on portfolio and intraday prices

Monthly updates

Dividends accrued

Yes

Yes

Source: SelfTrade

ETFs render many alternative asset classes investible to those investors who might otherwise find it difficult or impractical to participate. As sizeable sums of money are often required in order to become direct participants in

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96 Source: ‘An Introduction to Exchange Traded Funds’, SPA Exchange Traded Funds.

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asset classes like private equity, it is difficult to achieve suitable diversification, management costs can be high, the administration can be complex and, particularly important, they are illiquid. Using ETFs to invest in alternative asset classes such as private equity solves these problems. They are simply listed investments that track the indices of the listed companies operating in these fields. In contrast, it needs to be noted that investing in asset classes like these through ETFs that track the relevant indices of listed companies will result in more volatility in capital value than investing in private equity investments or funds of physical investments in the field. This fact risks undermining the socalled ‘low correlation’ argument for alternative investment.

Popularity of Islamic Private Equity Islamic finance has witnessed remarkable growth in recent years, both in terms of the expansion of the entire industry and in terms of the development of new and more sophisticated products that cater for the increasing yet unmatched demand for structured products which abide by the principles of Shari’ah law. The Gulf Cooperative Council (GCC) nations have experienced a spectacular economic boom driven by oil price increases in recent times. According to industry reports, these countries witnessed a 6.1% GDP growth between 2003 and 2007 and have liquidity estimated by KMPG to be in excess of US$2.3 trillion.97 Simultaneously, the Islamic finance industry keeps on growing unabated, having an estimated US$750 billion in global assets growing at 15–20% annually – with the GCC accounting for two-thirds of its size (S&P and HSBC analysis). The consequence of these two trends is a boom in private equity investments in the GCC and the broader MENA (Middle East & North Africa), which includes a growing trend for Islamic private equity funds as well. According to the 2007 Dow Jones Private Equity report, the MENA region has raised $16 billion since 1994, of which $10 billion were raised in 2006. $1.1 billion are estimated to be in Islamic private equity funds.98 Industry experts assert that private equity is a natural fit for Islamic investors, given that at the core of Shari’ah principles, money should be directed to the real economy through investment in companies that offer ethically acceptable products and services. This means that returns should be earned through active involvement and participation in the business risk in Shari’ahcompliant investments. 97 Source: Rafi-uddin Shikoh. ‘Opportunities in Islamic Private Equity’. Dinar Standard, 22 November, 2007. Available from http://dinarstandard.com/finance/ IslamicPE112207.htm. 98 Ibid.

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Islamic private equity and venture capital funds must adhere to the following basic requirements: 1. Underlying asset: The underlying or ultimate asset, which is the subject of the investment, must be acceptable and halal. 2. Structure: The proposed structure itself is acceptable from a Shari’ahcompliant perspective.

Underlying Asset The ultimate or underlying asset must be halal. A case in point is that in a realestate investment fund, the following will need to be taken into account: 1. The occupiers of the real estate must conduct Shari’ah-compliant business or something which is not intrinsically haram. Various rules have developed over the last few years as to what percentage of income from a realestate asset can be haram and will not ‘taint’ the underlying investment. 2. No element (subject to paragraph 1 above) of haram activities, such as pornography, gambling or the sale of alcohol or pork products, should be included.

Structure In addition, the proposed contract, financing and instrument structure itself has to be Shari’ah compliant: 1. A vehicle in which funds are invested must be structured in a Shari’ahcompliant way. This, especially, factors in that the activities of the vehicle are based on tangible assets and are not speculative in nature (gharar). 2. The structure of the vehicle must provide for a prohibition on haram activities. 3. The activities of the directors and officers must be acceptable in nature and there should be the possibility of ensuring that their activities are conducted in a Shari’ah-compliant fashion.

Fundamentals of Private Equity in the MENA Region

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In recent times, the MENA region has seen a remarkable interest in the global private equity industry. Industry observers believe that the Middle East will become a major equity centre of the world in the near future. As of November 2007, there were a total of approximately 40-plus MENA region-based private equity players, which have grown manifoldly since 2005.

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Figure 7.1 MENA Region Private Equity Raised, 1997–2006 12,000 (US$ millions)

10,000 7,075

8,000 6,000

4,379

4,000 2,000

3

76

0

132

78

1,047

685

321

0

1997 1998 1999 2000 2001 2002 2003 2004 2005

2006

In a report by Zawya and KPMG, as of mid 2006 there were an estimated US$13 billion in private equity capital currently under management, of which 90% had been raised in the previous two years. Also in 2006, the average fund size had increased to US$284 million, a threefold increase from that in 2003, when the average fund size was between US$80 million and US$100 million.99 Figure 7.2 Sector Focus of Private Equity Investment, 1997–2006 ($ millions) Others, $403, 17%

Financial Services, $644, 28%

Real Estate, $158, 7% Travel and Tourism, $173, 7% Power and Utilities, $176, 7% Telecoms and IT, $205, 9%

Transport, $354, 15%

Consumer Goods, $240, 10%

Source: Zawya/ KPMG 2006

99 Ibid

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Sovereign Wealth Funds and Private Equity Sovereign wealth funds are state-owned investment funds that are typically created when governments have budgetary surpluses and have little or no international debt. More simply, SWFs are large government-controlled asset pools invested for profit. The scale of these funds is such that they dwarf other forms of investment capital. SWFs are believed to be greater than the global stock of assets invested in either hedge funds or private equity.100 Estimates place the value of SWF assets at approximately $3 trillion and forecast that numbers will quadruple to $12 trillion by 2015.101 In 2007, SWF assets grew by 18%.102 The largest SWF, the ABU Dhabi Investment Authority (ADIA), controls up to an estimated $875 billion in assets; exact figures are not available. Figure 7.3 shows the largest SWFs estimated in billions of US dollars. Figure 7.3 The Largest SWFs UAE Singapore (GIC) Norway Saudi Arabia Russia Singapore (Temasek Holdings) China Qatar Libya Algeria Australia US (Alaska) Kuwait Brunei Korea

100

200

300

400

500

600

700

800

900

1000

Source: Council on Foreign Relations and the Peterson Institute

104

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100 Source: Testimony of Under-Secretary for International Affairs David H. McCormick, Testimony before the Joint Economic Committee, dated 13 February, 2008. 101 ‘Sovereign Funds May Surpass Global Foreign Reserves’, Reuters, 11 March, 2008. 102 ‘Sovereign Wealth Funds grow to $3,300 bn’, Financial Times, 30 March, 2008.

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SWFs invest in blue-chip firms through major private equity firms and can participate as investors in specific investment funds or purchase an ownership stake in the private equity firm itself. Industry estimates of SWF commitments to private equity vary from $120 billion to $150 billion – or about 10% of all global capital available to the sector.103 Ninety per cent of SWFs have made some kind of private equity investment in the past.104 Commentators have noted that through their holdings, these private equity firms are among the largest employers in the United States.105

Attractiveness of Private Equity Partnership SWFs are seeking new ways to invest their increasingly large stockpiles of money. The use of ‘local partners’, like well-connected private equity firms, is becoming an attractive investment option.106 These SWFs are also aware that the secretive nature of private equity can provide cover for SWF investments. Private equity firms are not required to make regular reports to regulatory bodies, such as the SEC of the USA and the FSA of the UK, which is a requirement for publicly traded companies. Private equity firms do not have public shareholders’ meetings and operate mainly outside public scrutiny. Although SWFs have traditionally had the option of investing in individual investment funds raised by private equity firms, in recent times they have started taking ownership stakes in the overall private equity business as well. Typical examples are the May 2007 purchase of under 10% of the Blackstone group by China’s State Foreign Exchange Investment Corporation107 and the September 2007 purchase of a 7.5% stake in the Carlyle Group by Abu Dhabi’s Mubadala Development Co.108

Increasing Popularity of Private Equity Real-estate Funds In recent times, real estate has become widely accepted as a global asset class. Institutional, high net-worth, well-heeled and retail investors in search 103 ‘Prequin Sovereign Wealth Funds Review: Activity in Private Equity and Private Real Estate’, Private Equity Intelligence, Ltd. (2008): 4. 104 ‘Prequin Sovereign Wealth Funds Review: Activity in Private Equity and Private Real Estate’, Private Equity Intelligence, Ltd. (2008): 4, 8. 105 ‘Funds that shake Capitalist Logic’, Lawrence Summers, Financial Times, 29 July, 2007. 106 ‘Abu Dhabi Sets Investment Code’, Wall Street Journal, 6 March, 2008. 107 ‘Prequin Sovereign Wealth Funds Review: Activity in Private Equity and Private Real Estate’, Private Equity Intelligence, Ltd. (2008): 4, 8. 108 Ibid.

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of yield have embraced the unparalleled sophistication of real-estate markets. It is worthwhile to note that property investing is a long-term commitment so the effects of the credit crisis have not been taken into account in the declaration above. The hallmarks of private equity real-estate funds are deal size, the use of leverage, the implementation of opportunistic investment strategies and the sophistication of incentive arrangements. Nevertheless, at the time of writing, the private equity real-estate market has witnessed incomparable growth in the last few years. It has evolved from a niche sector of the general private equity world to an integral part of the industry. In 2007 for instance, after buyout funds, real estate was second in terms of aggregate funding with a record $92.2 billion raised during that year. Along with the growth in volume of real-estate private equity funds, the industry witnessed an increase in the number of different types of offering available. This range of funds is exceptionally diverse with vehicles having an emphasis on different types of property, at different stages of development, in various regions around the world. Returns from private equity real-estate funds ranked amongst the highest in the industry, with median Internal Rate of Return (IRR) in the range of 15% to 27% for funds of vintages 2000–2005.109 This has increased investors’ desire to get involved in real-estate investment and helped in the creation of real-estate fund of funds vehicles. These funds of funds have several benefits for investors including an expertise in fund selection and due diligence, access to elite fund managers and diversification across regions as well as types.

Funds of Funds The real-estate fund of funds subsector has been expanding steadily to meet the increasing demand from investors. Some fund managers utilise the services of a fund of funds manager with a view to gaining access to a diversified portfolio of real-estate investments as they lack the experience and funds to put together such a portfolio themselves. Others, however, use funds of funds in order to gain access to specific areas of the real-estate market. Funds of funds now exist alongside direct fund investments in an investor’s portfolio, where direct funds are focusing on an area where the investor in question has acquired the knowledge base, and the fund of funds investments are focusing on areas that the investor still desires to have exposure to, but lacks the experience to source and invest in those opportunities by itself.

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109 Source: Prequin. May 2008. ‘The 2008 Private Equity Real Estate Fund of Funds Review’.

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Figure 7.4 Funds of Funds by Geographic Focus 2006–2008 Yield to Date 14 12

12 10

8

8 6

5 3.7

4

3.3

2 0

1.4



US

Europe

Asia and ROW

Number of funds raised Aggregate commitments Source: Prequin, May 2008, ‘The 2008 Private Equity Real Estate Fund of Funds Review’

This demand for a more specific fund of funds has resulted in the creation of more targeted fund of funds vehicles where investments are restricted to one country or region. There is the likelihood that as investors have gained more experience in their home countries, they have become more proficient at carrying out direct investments themselves, and therefore have begun to utilise a fund of funds as a way of accessing other regions outside their territories, such as in Asia. It is important to note that the shift in focus is characteristic of the increasingly global nature of the private equity real-estate industry. Reports show that a number of funds focusing on Asia are being raised by firms located in the region; thus fund of funds managers with a local presence in Asia are better positioned to understand the intricacies of the Asian market and so select the best opportunities which institutional investors mostly based in Europe and North America may find difficult to assess as effectively. While real-estate funds of funds are still in their relative infancy, and even though they have experienced rapid growth in recent times, they will become

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an increasing source of capital for managers of real-estate funds around the world in the future.

Private Equity Investing in Emerging Markets

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Since the mid 1990s, there has been a global consensus that the private sector as opposed to the state should be the main accelerant for new investment and development, and a number of emerging markets were then showing signs of encouraging progress. Increasing growth was witnessed, inflation and interest rates were in the decline, the political and regulatory environments were now in favour of open markets and barriers to competition had become lower. It became evident that an increasing number of companies were in need of investment capital in order for the private sector strategy to succeed. Private equity appeared to be the obvious candidate to fulfil this need as it offers a number of advantages to users and providers of investment capital alike. As the private equity sector got bigger, an increasing number of companies transcended their conventional dependence on so-called ‘friends and family’ as sources of finance to enhance their businesses’ growth prospects and be competitive. But these companies had risk profiles as a result of their size and track record that made them unattractive, in terms of financing, to securities markets as well as banks. Infamously domestic equity and credit markets were open only to the larger companies, and international financial markets were even more difficult to penetrate. Thus, private equity appeared to be an attractive option in the middle of the financing spectrum. Investors were drawn to the huge shortages of capital in a number of emerging markets, which meant that there were low valuations (and hence high returns) for the increasing number of companies looking to raise capital. Additionally, a number of potential foreign investors were replete with funds as a result of the boom in financial markets and venture capital funds in industrial countries in the 1990s. Improving macroeconomic conditions, the new openness of governments to foreign investors, and the potential of the rewards of high returns persuaded investors to look at higher-risk investments in emerging markets. At the time, it appeared that emerging markets would succeed, given the harmony between supply and demand. It should be noted that in recent times the international private equity landscape in general has developed considerably. Until the advent of the credit crunch, deal sizes were continually increasing, the market was highly competitive, high premiums were being paid, and a number of trade buyers were habitually losing out to private equity firms. These conditions existed right through the more well-known private equity economies of the USA and the Europe. Nevertheless, the landscape in these markets is changing quickly, and there is the likelihood that the issues faced today will change significantly in a short period of time. The private equity industry is a world that is characterised by rapid change.

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In spite of these changes and uncertainty, emerging markets continue to attract interest from the private equity industry. In 2002, funds raised for private equity outside the USA and UK were less than 10% of the total.110 In 2006, funds raised for private equity to be spent outside the USA and UK were over 30%.111 The majority of these funds are diverted east into the Asia Pacific region. But, apart from China that is clearly attracting interest, opportunities abound in the entire region. Japan, Vietnam, Australia, Taiwan and India are all attractive markets for private equity, and will continue to be for the foreseeable future. There is a general consensus that private equity activity in Latin America and Africa is also on the up. The emerging market in India is one of the most exciting private equity stories. Indian private equity is attracting attention for a number of reasons including: ■ Its entrepreneurial status; ■ An investment base that has a true understanding of the multiple opportunities of private equity; ■ A rapidly developing infrastructure that has a sturdy, underlying economic growth; ■ The ease and advantages of the country’s English-speaking culture. These opportunities are even more attractive, given the more austere market conditions that abound elsewhere in more traditional private equity regions. There is a consensus amongst observers that the future is very bright for the thriving private equity market in India. Industry figures reveal that more private equity investments were made in India in comparison with China in terms of value, leading most observers to ask the question: Will India emerge as an equally or more attractive private equity destination than China? In 2007, private equity investments in India totalled US$17.13 billion across 339 deals, while in comparison there was a total of US$11.53 across 416 deals in China. Figures 7.5 and 7.6 show private equity investments in India and China in 2006 and 2007. A study by Evaluserve shows that as of 2007 there were 336 private equity firms operating in India and another 69 had raised, or were in the process of raising, funds with a total value of US$48 billion in investments in India from July 2007 to December 2010.112 It is not just China and India that are showing promise among the emerging markets. The other two countries in the so-called BRIC countries, Russia and Brazil, also show remarkable potential. In Russia, opportunities abound for private equity investing, given that non-bank financing is still underdeveloped and there is no legal definition 110 KPMG. (2008). ‘Private Equity Investing in India – A Survey of Private Equity Investors and their Portfolio Companies’. 111 Ibid. 112 Source: Evaluserve, (21 September, 2007), ‘An Indispensable Guide to Private Equity in India’.

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Figure 7.5 Private Equity Investments in India

Investment US$ millions Transactions

2006 2007 Growth %

Average Deal Size US$ millions

6,800 17,129

255 339

26.7 50.5

152%

33%

89%

Source: AVCJ.com, 7 January 2008, Volume 21 Number 1

Figure 7.6 Private Equity Investments in China

Investment US$ millions Transactions

2006 2007 Growth %

Average Deal Size US$ millions

6,925 11,525

263 416

26.3 27.7

66%

58%

5%

Source: AVCJ.com, 7 January 2008, Volume 21 Number 1

of venture capital. While in Brazil, even though pension fund investment in private equity is getting increasingly popular, the overlapping jurisdictions of regulators and tax authorities at the municipal, state and federal tiers, the burdensome judicial and tax systems, the inflexibility of the labour market and the cumbersome bureaucratic structures all impact negatively on private enterprise. In conclusion, these emerging markets may someday compete with Europe or the USA as a focus for private equity investors. Experts, however, warn that a sense of perspective is required. They assert that these countries have complex operating environments, an interventionist stance when dealing with private enterprise, and weak financial and industrial bases; hence they should be viewed as markets for the long-term future.

Private Equity Investment in Clean Energy When historians look back to weigh up the history of clean energy, the first half of the last decade will probably be viewed as the point at which the industry began its stellar growth. Experts predict that the global value of clean energy will rise from $12.9 billion in 2004 to $92 billion by 2013.113

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113 Polly Ghazi, (3 June, 2004), ‘Clean Energy Boom’. Green Futures. Available from www.forumforthefuture.org/greenfutures/articles/601854.

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The industry has entered the critical phase encountered by all major technology booms. As individual technologies mature, there is an inevitable churn of players: mergers, acquisitions, divestments, bankruptcies and – always – new market entrants. The consequence is a constant rising and falling of prospects for companies, and even entire sectors, that is variously fascinating or alarming. However, it is never unexciting. As a consequence, venture capital and private equity investments in clean energy companies saw a huge rise in 2006, increasing by 167% from US$2.7 billion to US$7.1 billion. The driver for the increase is a surge in money flowing into the US biofuels sector. Solar, wind and other low-carbon sectors, such as energy efficiency, smart distribution and carbon markets, also witnessed significant rises. According to Financial News Online, the clean energy sector received a record number of investments from venture capital and private equity firms in 2008, following a surge of US$5 billion in the second quarter.114 Investment in clean energy technologies could exceed $7 trillion by 2030 as public policy and private investors continue to underpin a major shift in the global energy mix.115 Figure 7.7 Clean Energy Projected Growth 2004–2014 (US$ billions) Wind power

$48.1

Solar PV Fuel cells

2004

$8.0

2014

$39.2 $7.2 $15.1 $0.9

TOTAL $16.1

$0

$20

$102.4 $40

$60

$80

$100

$120

Source: Clean Edge, 2005

114 Source: Oliver Smiddy, (6 August 2008). ‘Clean Energy Investment Hits Record $8.4 billion’. 115 Source: Business Green Staff (7 February, 2008). Clean energy investment to top $7 trillion by 2030. www.businessgreen.com/business-green/news/2209110/ clean-energy-investment-top.

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The Investment Process This chapter discusses the investment process in private equity funds.

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Introduction In this chapter, the investment process is discussed both from the perspective of a company looking to approach a private equity firm for investment and from the investors looking to invest in a private equity firm’s fund. The first section will cover the former while the second section will cover the latter.

Investment Process – Target Company’s Perspective Introduction The discussion of this investment process will be centred on a fictional company, Biz Technologies, that is looking to expand its offerings in the financial software market as well as enter new markets in order to fulfil its goal to be a major player in the global financial software marketplace. The visionary CEO of the firm, Mr Vince Esscoba, is looking for external finance to help the company achieve its goal. Given the scale of the investment required, the executive team of the company is looking to approach a private equity firm. There are, however, a few things that Mr Esscoba and his team have to take into account and they include: 1. Private equity cannot fund every company. 2. Due to the nature of the private equity financing model, private equity funds need to ensure a higher profit than other types of investment available to institutional investors to compensate for the amount of time the capital is tied up. 3. The private source of the capital and the need to be involved with the companies financed over the medium and long term, dictate that only the most dynamic companies or those with the greatest potential for growth are selected.

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The term ‘deal flow’ is used to denote the number of investment opportunities available to a private equity firm. Good-quality deal flow is a crucial ­factor in the success of a private equity firm. The fact that a very small percentage of business plans received by private equity players result in the fund taking an equity stake in the company shows how selective the process is. Private equity firms typically restrict their investments to companies, or future companies, that match up to the investment criteria. Even in cases where these criteria are met, a long process of analysis could still result in refusal if an agreement cannot be reached on the entry price or if the detailed analysis (due diligence) reveals that the proposed investment does not match up to expectations.

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The rejection of an investment proposal does not necessarily mean that the business is lacking in quality, but that the characteristics of the business do not go with the set criteria of the private firm in question. Or it may mean that the private equity fund has already invested enough in the line of business that Biz Technologies, or any other company seeking investment, operates in. Companies are aware that not all businesses are suitable candidates for private equity investment and that a company’s stage of development may not yet match a particular private equity fund’s criteria. Nevertheless, it is ­beneficial for the company to know the reasons for the rejection of the investment opportunity. This can, every so often, allow the company to adjust its projections, to deepen its study of the market or to make some changes to their team before approaching other investors.

Writing of the Business Plan The process of attracting private equity begins with the preparation of a business plan. Biz Technologies then sends this to several private equity firms. The business plan is the principal tool used by the financial investor for the evaluation of the prospects for the business. Most of all, it is the first point of contact with the investors. The company management prepares this business plan, taking into the account the fact that private equity investors will want to learn what the company’s management team are planning to do. A business plan fulfils two major functions: 1. It compels the business’s management team to set their objectives. It encourages them to take a hard look at the business with a view to identify­ ing what their offerings are, as well as to set strategies. The Biz Technologies management team has a clear vision of their business activities and forecasts the performance it expects, and sets out the business model it intends to adopt. All this is translated into its business plan, which covers all these strategic choices. 2. The business plan is the point of contact with the private equity firms that Biz Technologies approaches. The business plan is used to express the unique essence of the company. It must arouse the interest of the investors and inform them exactly about the reason the business deserves their serious attention. Essential points covered in the business plan include: ■ ■ ■ ■ ■ ■ ■

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Company history; Management team; Products and services; Analysis of their market and competitors; Financial projections; Capital required; Exit possibilities.

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Selection of a Private Equity Firm A business plan is completed with input accepted from the company’s professional advisers. The management team now chooses which private equity firm to send it to. The selection of a private equity firm is a vital step, which can seem to some extent a gamble. The team selects only those private equity firms whose investment preferences align with its investment stage, industry and geographical focus, and the investment size required by its business proposition. Private equity firms generally try to differentiate themselves through the quality of their services. They also share with the prospective client companies their experience, their information, and their strategic thinking as well as opening up new alliances or bringing in new sources of capital.116 This source of advice and support, which transcends the mere provision of capital, is important. Experience shows that less than half of private equity-financed businesses select the private equity firm offering the highest valuation.117 Instead, the added value created by the firm’s reputation, their knowledge of the market and their network contacts is considered more essential. The management team completes a selection process and then contacts two or three of them and sends them a summary of its business plan, keeping a more detailed plan for its first interviews. As it is normal for the team to be concerned about the confidentiality of the data it is giving out, Mr Esscoba asks the private equity firm to sign a confidentiality letter after their first meeting and waits to see if discussions are likely to proceed.

The Negotiation Process There are a number of stages in the negotiation process between the company and the private equity firm. The following is a list used as an illustration and is provided as a path those negotiations most frequently take. However, every negotiation is different.

The presentation of the business plan and first analysis At the first round of meetings with potential private equity firms, they would want to confirm their initial impressions through questions such as: 1. Does Biz Technologies have the potential to achieve sustained growth? 2. Does the management team have the necessary skills?

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116 European Private Equity and Venture Capital Association, (2007), ‘Guide on Private Equity and Venture Capital for Entrepreneurs’. An EVCA Special Paper. 117 ‘What Entrepreneurs Pay for Venture Capital Affiliation’, David H. Hau, Journal of Finance, Wharton School, August 2004.

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3. Does the probable return on investment justify the risks taken? 4. Is there a match to the fund’s investment criteria? In the course of these presentations, the team discusses its plan in more detail. Mr Esscoba begins further discussions with a potential private equity firm and asks to see a simplified presentation of its portfolio and the initial results of its investments in order that his management team can assess its performance and the support it offers the companies in its portfolio. The questions he asks the private equity firm include: 1. 2. 3. 4. 5.

How much investment do they manage? Are the founders still present in the companies they have invested in? Is it possible to meet the heads of the companies concerned? How many companies have already divested? Do they continue to back up the companies they invest in by follow-on investment?

Initial negotiations As the first contact was satisfactory for both parties, the private equity firm begins to negotiate the conditions of the transaction with Mr Esscoba and his team and offers an initial memorandum. This sets out the broad guidelines for future negotiations. The private equity firm then takes each section of the business plan and verifies it using its knowledge of the technology sector and its previous investments. Biz Technologies’ advisers have a significant role to play in helping the company select the best proposals at each stage of the negotiations. It is not sufficient for the company to simply make a comparison between the valuations that it is offered. The company analyses the non-financial elements of the alliance under consideration: the role of the board of directors, investment conditions, strategy, exit strategies preferential right, the manner in which the shares could be sold, etc. In addition, the financial and legal structure of the operation (investment) is also included in the discussion. The financial structure of the operation should contain a good balance between the risks and the returns expected by both parties. The private equity firm and Biz Technologies now work out the value of the company. There are various sophisticated financial instruments available to organise the investment, and private equity fund managers habitually use a combination of equity, debt and quasi-equity to cater for the specific needs of each business. Staged financing allows the private equity firm to release its financing at certain stages; for instance during the development phase or launching of a product, or when the company enters a foreign market. This could also occur when the company requires an increase in its production facilities. This restric-

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tion of the entire investment to each one of these stages allows the private equity firm, by the very nature of the deed, to limit its risk. The price negotiated for the equity is especially important. For Biz Technologies, it determines the amount of equity transferred and the consequences for the control of the business. This amount could simply be the exact amount of capital needed; the company might also choose to give up more equity than it needs to avoid having to make further requests for external finance, which in most cases takes up a lot of time and effort. For the fund manager, the price will be the basis on which the company’s eventual performance is judged, and the basis of the company’s ability to give money back to its investors and to benefit from part of the eventual added value. The price proposed by the private equity firm is close to what the company wanted and they accept it. To Mr Esscoba and the management team, the provision of capital is of more importance to their company in the long term than small gains in the valuation process:

Due diligence When the due diligence phase is completed, the private equity firm decides to invest in Biz Technologies. The investment manager at the private equity firm devotes a great deal of time and resources to the due diligence process and calls in external consultants. Lawyers, tax advisers, accountants, experts in insurance and environmental risk forecasting and intellectual property consultants, among others, will help the private equity firm in the analysis of all aspects of the business and the information that Biz Technologies provided. At this stage, the private equity firm has access to all necessary information and discusses changes required in the organisation, based on the conclusions of the several studies and audits undertaken.

Final negotiations As the in-depth analysis of the company has proved satisfactory, Biz Technologies will embark upon the last stage; negotiating the final terms and conditions. This is the stage at which the transaction is legally secured.

Signing of the agreement This is the stage at which Biz Technologies and the private equity firm, Esscapital Partners (the investors), sign up to the capital increase and the lenders make the funds available.

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The Investment Process

Relations with the Private Equity Firm Now that an agreement has been signed with Esscapital Partners, an investment relationship has begun between the two parties. As seen from previous chapters, one of the distinguishing aspects of the private equity business model is that the money invested is not owned by the fund managers but by the institutional investors such as pension funds, insurance companies, etc. Private equity firms are, in effect, intermediaries between capital providers and companies that require capital. There are profound changes to the company that are associated with the acceptance of funds from external investors such as private equity firms. Since Mr Esscoba has allowed a third party to take a stake in Biz Technologies’ equity, then he and his management team must be prepared to allow them to partake in strategic discussions and for there to be transparency in their decision-making processes. A shareholder’s agreement between the two ­parties will help establish the principle of joint decisions and help balance the interests of the shareholders. The principle role of the private equity firm in this relationship is to help Biz Technologies create or develop the value of its business by engaging in the follow-up process.

Biz Technologies and Esscapital seek to Achieve a Common Goal: Balanced Growth Biz Technologies establishes a permanent dialogue with Esscapital. The contact between the two parties centres around strategic discussions. Esscapital’s experience, which has been accumulated from other businesses in its port­ folio, will be invaluable when it comes to: ■ ■ ■ ■ ■ ■

The organisation of subsequent rounds of investment; The establishment of financial reporting procedures; Reaction to crisis situations; Negotiation with the banks; Seeking additional shareholders; Recruiting members of the management team.

The Different Roles Played by Private Equity Firms Esscapital has the option of playing the following types of role in Biz Technologies: ■ Hands-on/hands-off approach – Some private equity firms play a more active role in the investee (portfolio) company than others, depending on the type of investment fund and how developed the company’s business is.   Start-ups and some other special situations require the private equity

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firm to operate closely with the management team of the investee company and it therefore takes a ‘hands-on’ approach. On the other hand, if it so happens that the company is more developed, the private equity firm will be dealing with a more experienced team. In this case, the approach can be described as ‘hands-off’.   Regardless of whether the approach is ‘hands-off’ or ‘hands-on’, the private equity firm is not usually involved in the day-to-day running of the company and it places its trust in the company’s management team. The firm will only be involved in day-to-day operations with the management team when there is a serious crisis. ■ Their place and role on various committees and boards – A number of private equity firms typically request a presence or representation on the board of directors or the supervisory board. This level of participation lets the company take advantage of the experience of a more active board member. ■ Investors’ liability – Given that they have a seat on the board, private equity firms have a considerable duty of care to other shareholders and creditors. Since they have a special financial background, they help the company detect any signs of crisis: a sharp rise in fixed costs, deals agreed at non-revisable prices, deterioration in credit control, an uncontrolled expansion in investments, high staff turnover, etc. Since Biz Technologies is a relatively mature company, the approach taken by Esscapital is more of a ‘hands-off’ approach.

Private Equity Exit and End of Investment Relationship Exits are the most essential elements of the private equity business. When private equity firms take an initial decision to invest, they incorporate the planning of their exit route. There are a number of ways in which a private equity firm can exit from an investment and these include:

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1. Trade sale – This is also known as mergers and acquisitions. It is a sale of privately held common equity and is the most common type of exit strategy. Large and small companies are often complementary to each other and a union between them lets one of them gain a strategic advantage or completion of its own business activities. This makes the complementary business more appealing to a buyer and allows it to attract a premium price. 2. Management team repurchase – This type of exit strategy is becoming more popular as a proven route. It is a very appealing exit for both the private equity firm and the company’s management team if the company can provide the assurance of regular cash flows and the mobilisation of adequate loans.

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3. Sale of investment to a secondary market investor – In this case, one financial investor may sell its equity stake to another one in the event that the company no longer matches up to the investment criteria of the original fund. 4. Initial price offering (IPO) – This is the most spectacular exit route. It is, however, not the most widely used, even in a stock market boom. Stock market flotation is usually as a result of a real desire to improve the dynamism of the company in the long term and benefit financially from the growth possibilities provided by a stock market. Thus, the equity share placed on the market (the float) must be of adequate proportions to make sure there is liquidity, a compensation for appealing to the market. A flotation marks the start of a lengthy process of development.   Floatation brings about positive impacts such as: ■ Access to funds for growth and acquisitions; ■ The means to keep hold of or draw in quality staff through share incentive schemes, i.e. stock options; ■ The opportunity to fund acquisitions with stock as opposed to cash; ■ Realisation of a portion of the shareholders’ capital; ■ Making the company more credible and visible to clients, suppliers and partners; ■ Increasing the potential for private equity to exit from the investment.

Biz Technologies has to be aware of the challenges that the stock market can bring about, since listing on an exchange can make a business more visible and hence increase scrutiny from financial analysts and the media alike. Mr Esscoba will also need to make himself more readily available as soon as the company floats. 5. Liquidation – This is clearly the least favourable route and happens in the event that the efforts of the chief executive and the private equity firm have failed to save the company. From the above, it is likely that for a firm with a profile such as Biz Technologies’, the exit route will be via an IPO.

Valuation of the Investment on Exit In a similar way to a private equity firm’s entry into the company, the valuations carried out during a partial or complete exit will differ depending on the sort of operation, the number of shares sold off, the sector that the business operates in and the characteristics of the company.

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Investment Process – Investor in Private Equity Firm’s Perspective The investment process from a private equity firm’s perspective is to be discussed in this section. First of all, it is prudent to discuss the skill sets of private equity managers that inspire confidence of potential investors.

Summary of Key Skills Successful private equity managers must possess a number of key skills. Some of these are described below.

Focus on business plans As stated in the previous section, business plans are offered to private equity firms in the hope of securing an investment. These plans will be carefully ­analysed prior to an investment. Scrutinising a business plan and helping to create the conditions for its effective execution is one of the major areas where private equity managers can add value to their portfolio companies. Figure 8.1 Skill Set of a Private Equity Manager

Focus on business plans Selectivity & ­specialisation

­Governance & control

Value added focus

The skill set of a private equity manager

Strong management

Ability to negotiate

Inside information

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Selectivity and specialisation Private equity managers of distinction will usually see a large number of potential transactions each year, which allows them to be extremely selective, only going with those where they have the knowledge and capability to add value. A complete technological and operating knowledge of these opportunities is also increasingly essential.

Ability to negotiate A private equity manager is able to legally access inside information such as management projections in its investment process, which is not possible with the purchase of quoted securities. This allows the private equity manager to negotiate more favourable terms for their fund.

Strong management The strength of the management, both within the private equity firm and the company itself, is vital to the success of an investment. The private equity manager will rely heavily on the managers of the company in the day-to-day operations of the business.

Value-added focus The alignment of ownership and management occurs in private equity to a greater extent than is usual with investments in quoted securities. Furthermore, the private equity manager will become involved in the strategic direction of the company and the risk management of the business. Leveraging through debt, popular with those engaged in buyout transactions, compels the private equity manager to have more aggressive business plans.

Governance and control The private equity manager regularly has control or influence to a certain extent, allowing strategic and, in some cases, operational intervention when required, unlike the governance structure of a listed company.

Due Diligence Due diligence is to be discussed in this section and will be covered from an ­investor’s perspective, i.e. the high net-worth individual or institution that is looking to commit funds to a private equity fund.

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From an Investor’s Perspective For starters, it is necessary to consider the importance of manager selection. The main criteria for private equity fund selection typically relate to the qualifications of the management team. There are variations in performance among managers in the private equity market that are more diverse than in quoted securities markets.

What Investors are looking for in a Potential Fund Investment? Investors typically evaluate the credentials of each manager through the close investigation of their track record and reputation. A track record of a manager can be indicative of their success in the future. Some of the major considerations include:

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1. Investment strategy and market opportunity – This is an important consideration as a fund investment strategy should be clear and similar to that in which the track record of the manager has been established. The track record should provide evidence of a disciplined approach and the ability to stick with the articulated strategy. There should be clear justification for the sums of money being raised by the magnitude of the perceived investment opportunity and the extent of the resources of the manager. The investment strategy ought to be attractive in the context of the wider economic environment, which will have an effect on the market opportunity. 2. Track record – This is the level of publicly available statistics of investment performance. The public availability and transparency of data such as this are vital for precise benchmarking of funds by sector and vintage year. Prospective investors often scrutinise internal rate of return on investment in concert with multiples of the original costs realised.   The quotes for returns are often on a gross and net basis. The gross return represents the investment return to the fund and does not take into account the fees and expenses of the fund or the dilutive effect of holding uninvested cash, while the net return represents the investment return to investors. Net return is also known as the cash on cash return. 3. Investment team – There will be an emphasis on the individuals that make up the management team – how they are incentivised, and the past and future continuity within the team – when assessing the ability of a manager to reproduce erstwhile superior performance. The management team should be highly experienced in being a private equity manager. In addition, other attributes such as relevant operational, sector or scientific experience are helpful. A significant consideration is whether there is cohesiveness between members of the core management team, achieved through working as a team for a considerable amount of time, and whether team members have been leaving the core over time.

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Fund Investment Due Diligence If an investor is satisfied that a private equity fund meets its preliminary criteria, due diligence begins. There is an ongoing debate about how long a due diligence process takes. In reality, the length of the due diligence phase varies widely, given that it depends upon the complexity of the fund, its geographic remit, the size of the manager’s organisation and the availability and quality of the information supplied by the manager. Furthermore, investors have varying levels of sophistication and knowledge, and often focus more on certain aspects of the process than on others. In general, investors evaluate a basket of both quantitative and qualitative factors, which can be grouped together under the following areas among others, depending on the level of sophistication, and assessed using the techniques described below.118

People Assessment of the manager’s team, organisation, individuals’ experience and remuneration structure involves: ■ Multiple face-to-face meetings, including visits to the fund manager’s offices; ■ Interviews with investment professionals, alone, and in groups, formally and informally; ■ Organisational, ownership and remuneration analysis; ■ Detailed reference checks with portfolio company management, other private equity professionals, bankers, accountants, lawyers, investors and previous colleagues.

Process Assessment of the manager’s deal sourcing, due diligence, monitoring and exit process entails: ■ A complete portfolio review; ■ Assessment of the manager’s previous due diligence work, including checks on portfolio company files and monitoring systems; ■ Interviews with portfolio company managers.

Philosophy and investment strategy Assessment of the consistency and suitability of the manager’s strategy and its execution involves:

118 Probitas Partners, (2005). ‘The Guide to Private Equity Investment Due Diligence’. Private Equity International.

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Figure 8.2 Flowchart for a Private Equity Fund Investment Private Equity Funds Available in the market

Industry relationships

Research

Intermediaries

Fund ­relationship

Deal sourcing

Preliminary analysis Does not fit criteria

Due diligence Investment ­committee approval Negotiation and legal review

Commitment

Monitor and oversight

Exit and distribution management

■ Understanding of the market within which the fund manager operates; ■ Comparison of strategy and positioning with private equity managers targeting the same or similar markets (whether or not they are currently in the market with a new fund); ■ Analysis of trends in previous portfolios of the fund manager to test for ‘strategy drift’ (departure from a stated strategy); ■ Evaluation of the manager’s ability to carry out the fund’s stated strategy. Figure 8.2 depicts a typical decision-making flowchart for a private equity fund investment.

Monitoring

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Investors typically want to take on an active role in the monitoring of the activities of the private equity fund, although they are aware that it can be a resource-consuming exercise. Some private equity firms may be offered a position on the investment advisory committee of their fund, which generally focuses on investor and conflict issues.

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The Investment Process

A deep understanding of the strengths and weaknesses of the private equity firm’s funds and the associated investment strategy can be gained through a close working relationship with the managers of the firm. Investors typically want to build a close relationship with their fund man­ agers and ensure that they are able to set aside the right level of resources. As a result, a number of investors limit the number of private equity fund manager relationships that they maintain and to whom they commit funds.

A Viewpoint on the Importance of Due Diligence The fraud that was allegedly perpetrated by Bernard Madoff, the former NASDAQ chairman, exposes the insufficiency of the implementation of due diligence analysis undertaken by several investors and their advisers. Industry experts are pinning their hopes on the Madoff failure being a ­tipping point from which operational due diligence is given more serious effort. Sections of the investment industry have been negligent in recent years, and there is evidence of this negligence in events such as the ultimate failure of banks of late. Observers are unanimous in their belief that the Madoff scandal is the definitive failure as it involved a fraud which circumvented the majority of due diligence efforts by taking advantage of, in some cases, a reputation that exploited the personal relationship between managers and investors. The Madoff fraud story apparently began in the 1990s, when Madoff used his success as a market maker to help launch an asset-management firm. According to Time Magazine, Madoff raised money for his fund by taking advantage of his social network, often attracting investors at country clubs where he or family members belonged. At the Palm Beach Country Club, Madoff supposedly found a major investor who helped in drawing other members to Madoff’s fund. A number of Madoff’s clients invested in his funds through a number of feeder funds, which were sold by other firms. In a similar way to supermarket brands, the funds bore the name of the investment-adviser firm, which then forwarded the money to Madoff to be managed. A lot of these funds leveraged their own investment in Madoff’s funds, which could possibly magnify the losses felt by the collapse of Madoff’s firm.119 According to Time magazine, on the surface, Madoff’s funds appeared to be low-risk investments. His largest fund reported steady returns, typically gaining a percentage point or two per month.

119 Stephen Gandel, (12 December, 2008). ‘Wall Street’s Latest Downfall: Madoff Charged with Fraud’. Available from www.time.com/time/business/ article/0,8599,1866154,00.html as accessed on 16/02/2009.

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The following is a quote from Time magazine on how ridiculous the Madoff scheme became: Sometime in 2005, according to the SEC suit, Madoff’s investment-advisory business morphed into a Ponzi scheme, taking new money from investors to pay off existing clients who wanted to cash out. According to a form filed with the SEC, Madoff reported that the business had $17.1 billion under management in January 2008. As the market got worse this year,120 Madoff continued to report to investors that his funds were up – as much as 5.6% through the end of November. That would have been a remarkable performance. During the same time, the stocks of the Standard & Poor’s 500, where Madoff supposedly did most of his trading, had dropped a weighted average of 37.7%. The above shows that had thorough due diligence been carried out by investors and their advisers, they would have been able to see through the Ponzi scheme. A lot of investors have proven that their investment selection was on the basis of either personal relationships with the manager of the fund, word of mouth or historical performance. The Madoff failure provides evidence as to how a rigorous bottom-up due diligence analysis is the only concrete basis on which to invest in an investment scheme, be it a hedge fund or private equity fund. A lot of investors were not courageous enough to turn down such a highly recommended and sought-after investment. In conclusion, it is essential that due diligence covers valuation processes, investment strategy offshore structures and independent risk-monitoring processes in order to ensure the return of the funds committed to private equity investments. Figure 8.3 contains a summary of the different steps in the private equity investment process.

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120 Year meaning 2008.

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Exit

Source: ‘A guide to Private equity’, BVCA/PWC, June 2003.



■ Provide periodic ■ Monitoring management accounts ■ ■ Communicate regularly ■ with investor/s ■ ↓

Seat on Board? ■ Management accounts Monitor investment ■ Minutes of Board and Constructive input other meetings Involvement in major decisions

Disclosure letter Warranties and indemnities Memorandum and articles of association Shareholders agreement

■ Consultants reports ■ Accountants reports

■ Offer letter

■ Business plan

Reports

■ Disclose all relevant ■ Negotiate final terms ■ Draw up completion ■ Final negotiation and completion business information ■ Document constitution documentation ■ and voting rights ■ ■ ↓

■ Liaise with accountants ■ Initiate external due Due diligence ■ Liaise with other diligence ↓ external consultants

Conduct initial enquiries Value the business Consider financing structure

■ Review business plan

Private Equity Firm

Meet to discuss ■ business plan ■ Build relationship ■ Negotiate outline terms

Appoint advisors Prepare business plan Contact private equity firms

Entrepreneur & Private Equity Firm

■ Provide additional ■ Initial enquiries and negotiation information ■ ↓ ■

pproaching the private A ■ equity firm/evaluating ■ the business plan ■ ↓

Stage Entrepreneur

Figure 8.3 Different Stages in the Private Equity Investment Process

The Investment Process

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Common Systems Used in Private Equity This chapter discusses the IT requirements of private equity firms and provides a list of common systems.

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Introduction Private equity and venture capital firms have been big investors in IT technology firms at different stages in their development. Some of the foremost vendors in the IT industry, such as Cisco Systems and SunGard Data Systems, have at one time in their history been funded by private equity and venture capital firms. These firms must have had first-hand experience with the use of technology in business, given their level of involvement in the management of the companies they finance or acquire. They are also aware of the strategic importance of technology as a driver of business growth. The irony, however, is that while private equity funds have constantly refined their investment strategy with a view to developing better techniques for management of deal-flow in the interest of their investors and fund managers, they have not been keen investors in information technology and infrastructure for their own firms. Their main areas of focus have been to take advantage of intellectual and human capital. As organisations, these funds are usually operated by a small number of people and, until recently, it could be argued that they have not required considerable amounts of technology.

IT Requirements of Private Equity Funds121 A revolution is clearly afoot. Analyses of how and where technology enhances the efficient operation and risk management of the funds have emerged in recent times. More importantly, however, is the assessment by private equity funds of where technology may assist them in countering the criticism levied against them from a financial regulatory standpoint. There are factors that determine the development of an internal technology strategy, such as the size and scale of the investment portfolio. A typical example is the use of Microsoft® Excel, which is restricted to managing a very small fund with a small number of investments or limited number of partners. The use of MS Excel can be supplementary to an accounting system. However, accounting functions within these funds need to have the ability to undertake tasks such as the tracking of each fund’s investment performance and the allocation of costs, revenues and capital to partners and partner organisations within each fund. Just like venture capital firms, private equity firms need to manage increased volumes of quantitative and qualitative information that grow in line with the number and size of their portfolios. In general, private equity firms need to access databases containing essential and up-to-date information about investors, potential investments and acquisition targets. They need to track deal opportunities with deals-inprogress across time zones and by geographical locations. The resulting data

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121 This section draws on discussions in the paper ‘The Tech Requirements of Private Equity’ by Bob McDowall.

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allows the funds to evaluate the productivity of the deal pipelines. Current information for managing and tracking investment performance must be contained in the databases. These funds are looking for technology applications from vendors to improve communication and collaboration, track investment and revenue performance targets, monitor portfolios and manage deal pipelines. For all intents and purposes, a requirement exists for the tracking of fund ­performance and activity from the fund-raising stage to exit strategies and the eventual exit. An area of technology application that is proving to be particularly costeffective and secure and that is useful for private equity firms is virtual data room (VDR) technology. VDR systems are essentially secure document ­management systems which enable organisations to upload document libraries that can be accessed via a website from anywhere in the world. They provide for the secure, online dissemination of confidential information about transactions such as mergers and acquisitions and share sales. In the past, all physical documents related to a private equity deal or acquisition were stored in a conference room at law firms for the purpose of allowing teams of dealmakers to view them at specific times. No document was allowed to be taken out of the room. VDR technology, however, allows for the evaluation of available legal and financial data but excludes printing of the information, hence safeguarding that access. VDR systems provide for initial viewing by the deal-makers and allow the seller to give multiple buying teams current access to the same documents. Thus, the entire presentation can be structured and transparent. VDRs facilitate collaboration and sharing of information and enable many private equity firms to work together to structure deals. However, these firms need to have a common platform to work with lawyers so as to share documents in the run up to the arrangement of a deal. Of late, increasing pressure has been applied to private equity firms with regard to the transparency, or lack of, in the way they conduct their business. There have been proposals, notable among them that from the British Private Equity and Venture Capital Association (BVCA), to address this criticism. Included in these key proposals are: ■ Better aggregation and analysis of data; ■ Publication of annual accounts; ■ Dissemination of information of investors’ details by geography and type to wider stakeholders; ■ More thorough disclosure of leverage covenants122 and debt repayment schedules. 122 A covenant is a clause in a loan agreement written for the protection of the lender’s claim by keeping the borrower’s financial position approximately the same as it was at the time the loan agreement was made. Essentially, covenants spell out what the borrower may do and must do in order to satisfy the terms of the loan. For example, the borrower may be prohibited from issuing more debt by using certain assets as collateral (Farlex Financial Directory).

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To tackle a number of these issues, private equity firms have to adopt more granular reporting standards as well as provide an analysis of the complete history of capital-raising activities for their funds and the way in which amounts are allocated. Database access provided to investors and other stakeholders with the requisite permission, allowing them to check performance of investment portfolios – perhaps over a web interface on a continuous basis with a password, would alleviate criticism of access as well as availability of information. The proliferation of private equity funds and the underlying investors’ demand for continual prices have given rise to the need for a continual form of market ­pricing that is key to the management of risks. A significant step towards meeting this demand could, for instance, be by offering for sale, from time to time, equity stakes in the investments made by the fund via an exchange. Continual pricing could begin with a straightforward bulletin board and the scale and sophistication could be improved upon in accordance with demands for ­market exchange services and facilities. This offers the optimal mechanism for price discovery, coupled with the capability of pricing the elements in the portfolio on a continual fair market price basis. In recent times, there have been a number of initiatives geared towards the establishment of a market in private equity underlying investments in the form of alternative investment exchanges, which could provide liquidity to the private equity market, possibly at the lower end of the market or on a smaller scale. These exchanges could give private equity managers the choice of running their portfolios on more traditional lines. There is increasing pressure on the private equity industry to be more open about their investment processes and performance to give rise to greater transparency. This will be an accelerant for more focused technology strategies. The use of technology tools and data applications will allow the demands of mainstream investors, financial regulators and governments to be met with respect to transparency.

Profile of a System

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Private equity firms have traditionally depended on Excel® spreadsheets for manual processing of the portfolio reporting process, which includes capture, administration, use and reporting of performance information of portfolio com­panies such as financials, ratios and valuations. However, the problem is that private equity firms usually receive several reports containing financials and other performance data in different formats and structures from their portfolio companies on a monthly basis. The private equity firm then has to re-key data, perform calculations of valuation and ratios and create summary reports, using spreadsheets most of the time. Spreadsheets are tools that are useful for many things, for example financial modelling, as a result of their flexibility and universal adoption. Never-

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Common Systems Used in Private Equity

theless, in the reporting process of private equity funds, the following issues exist: ■ ■ ■ ■ ■ ■ ■

The reporting of data makes the process time-consuming. They are inaccurate and prone to errors. There is inadequate version control. There are no data recovery capabilities. There is a lack of traceability of changes. There is a lack of drill-down capabilities. Keeping track of long time series can be onerous.

The dearth of dependable, rich-featured and user-friendly financial and business performance information of portfolio companies is especially difficult for a private equity firm as it inhibits its capability to anticipate deviations and promote corrective actions that have a direct impact on the creation of value to their investors. Figure 9.1 Interaction between Business Users and Portfolio Companies LPs

Pipeline manager

Fund administration

CRM Invest Rel

Portfolio monitoring

Portfolio companies

Source: Baxonpe

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Software as a Service Used for Portfolio Management Improvement The solution to the problem can be found in web-based solutions that are provided as Software as a Service (SaaS), which can be used to transform the process of capture–report–use for performance information of portfolio companies. This service can be of benefit to private equity and venture capital firms that would like to add to their existing system infrastructure with an online solution that lets them understand the situation in their portfolio companies in real time. With this type of service, it will be possible for portfolio companies to update their financial information directly into the system via a secure internet connection. Financials and other performance data can be stored in a central database. The service can also let business users, such as GPs, create dynamic dashboards and reports with key indicators, graphs, traffic lights and alerts that can be remotely accessible to deal executives or exported to files like MS Word® or a PDF, from any location and at any time. .

Figure 9.2 Interaction between Business Users, Portfolio Companies and the SaaS Portfolio companies

Internet/VPN/Extranet

Users

Partners

Baxon PMS

Inv. directors

Fund administrators *Adapted from the paper ‘Improving Portfolio Management in Private Equity’ by Baxon

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Common Systems Used in Private Equity

The flexibility offered by this type of service can allow varying levels of information to be captured. For instance, companies with low exposure might submit only key indicators while those with larger ownership and exposure are able to create more detailed performance drivers. The software can be updated using Excel spreadsheets or by populating online forms, meaning that business users, such as company Chief Financial Officers, need not alter their existing reporting structure. The functionality provided by this type of SaaS can enhance the core strategic capabilities of a private equity firm in that it provides the ability to work together with the management teams of portfolio companies in creating value for their firms.

List of Systems

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System

Vendor

Uses

Front Invest

eFront

Used by venture capital investment teams for deal-flow tracking, fund administration, IRR calculation and automated reporting.

ProTrak Protrak Advantage CRM International

Used in private equity firms for investor profiling, pipeline/opportunity management and supporting compliance management.

Relevant EquityWorks

Relevant

The modules of this system are used for portfolio management, deal management, fund management and investor relations.

Privatei

Burgiss Group

The core functionality of this system is used by private equity firms for deal prospecting, performance, contact management and fund commitment tracking, and to capture the details of underlying portfolio holdings.

Deal Dynamo

Netage Solutions

Used by firms across the private equity investment spectrum for deal management, fund raising and contact management.

Fund Dynamo

Netage Solutions

Used for fund manager due diligence, profiling fund managers, tracking of underlying funds (vintage, type etc.) and portfolio investments.

Baxon Portfolio Management System

Baxon

Software as a Service (SaaS) used for portfolio management.

Deal Director

Action!

This is a SugarCRM-based application for managing the life cycle of deals for private equity and venture capital firms. It is used for creating opportunities/deals automatically based on web submission of business plans and for securely sharing deal information with other investing firms.

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IT Projects This chapter discusses the IT projects that can be executed at private equity firms including the implementation of data warehouse appliances.

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Introduction As seen in previous chapters, private equity firms are increasingly engaging in syndication in order to clinch the bigger acquisition deals in the market. This means collaboration with other private equity firms and other firms involved in closing these deals, such as investment banks, law firms and the target companies. The implications of the above from an IT perspective are that there will be an increasing amount of data to be analysed and processed and the security required to protect confidential data will be higher on private equity executives’ agenda. Furthermore, as seen in Chapter 9, increasing pressure has been applied on private equity firms of late with regard to transparency, or lack of, in the way they conduct their business. To allow for transparency, these firms have to look for novel and cost-effective ways to aggregate and analyse their data as well as publish details of investors by geography and type to a wider circle of stakeholders. IT projects will therefore need to be planned and executed in the private equity firms primarily for the purpose of compliance with regulation and to ensure a more streamlined operation geared towards achieving better returns for their investors. In this chapter, a number of IT projects that could be of use in a private equity firm are discussed.

Implementation of Data Warehouse Appliances The Business Case

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In general, as businesses grow, their information needs escalate. The sheer volumes of data that businesses are confronting have skyrocketed. At private equity firms, this will be the case in the near future. In the bigger firms, with the advent of syndication in private equity investments and club deals and increased financial regulation in the industry, the amount of data to be stored and analysed will be on the increase. Furthermore, as databases proliferate, it will become increasingly difficult for people to find and access the information they need. Data warehousing has traditionally been an effective way of harnessing data from disparate systems and in this capacity is an enabler of business intelligence. But, as data volumes and systems continue to grow, so do the IT investments. Management will begin to have pressing concerns about scale, complexity and cost. Whereas data warehouses at first solved a problem that had only been tackled with customised programming – namely accessing business informa-

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tion for the purpose of analysis – they are, however, difficult to acquire and maintain. The process of finding the right technology, integrating it into the existing IT infrastructure, and the installation and configuration of it all need specialised skills. The procurement, configuration and installation process itself can take months. As soon as the data warehouse is in place, there may be performance or processing inefficiencies that threaten its use to grapple with. Many IT organisations have had to seek upgrade patches from their vendors before the initial system was even installed. And budgets for upgrades, once routine, are now thoroughly examined by senior management looking to cut costs. And if pressure from the business is factored in, then a hard struggle between efficiency and innovation can ensue.

The Advent of the Data Warehouse Appliance The comparatively low-cost data warehouse appliance aims to make data warehousing – or at least a useful class of data warehouse applications – ­reasonably priced, undemanding and easy to implement. Data warehouse appliances promise to ease the burden from data warehouses and other platforms that are bulging under the weight of escalating data and processing. There is a captivating argument for utilitarian products to support specialised needs. After all, other so-called appliance technologies have already lived up to their promise. Storage appliances, for instance, offered quick and easy additional storage for one or many servers. Storage appliances eliminated the complexity of operating system and hardware configuration parameters, significantly streamlining installation and set-up. IT staff could simply plug the appliance into the network and configure access with a simple wizard-based utility, a far cry from the classic configuration efforts that require significant time and training, and administration and management skills. In the event that a computing platform was removed from the network, the storage appliance could simply be moved, or ‘repurposed’, to support another one. Security appliances are yet another example of appliance technologies that achieved acceptability in the marketplace. They allow busy practitioners to secure a corporate network without having to understand the characteristic firewall functionality, protocol issues or port configuration details. Like storage appliances, they were GUI-driven tools that did not demand sophisticated skills or time. Indeed, security appliances were so successful that most firewall products now reflect their benefits. Data warehouse appliances are a logical evolution. For IT organisations with everlasting ‘to do’ lists and users crying out for more data warehouse resources, appliances offer a quick triumph. While IT managers might initially

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be worried about the addition of ‘yet another vendor’ with the introduction of the data warehouse appliance, the proliferation of packaged applications that require underlying data and processing ultimately renders data warehouse appliances less burdensome – since they require far fewer resources to ­manage them and offer staff economies of scale. In the end, data warehouse implementation shouldn’t be the focus; it’s a means to an end. The goal is to deliver a solution to support an immediate business need.

The Business is the Driver for Adoption Opportunities to leverage data warehouse appliances are growing, given the time and flexibility benefits they offer. In reality, many data warehouses aren’t true data warehouses in the strict sense, but a storage environment, useful in many ways, where IT and business users create their own tables for what is often a one-time-only task. In many organisations, the IT staff or the skills necessary to maintain a robust and cross-functional database for the purposes of enterprise reporting or adhoc queries are simply not in the budget or not even considered at all. This is especially true at private equity firms, given their relatively small size. Data warehouse appliances are able to plug this gap by providing a separate and well-designed platform for reporting. In some cases, the appliance may evolve into the company’s de-facto ‘single version of the truth’. However, there is more of a correlation of the long-term prospects of data warehouse appliances to business needs than to IT capabilities. As they become more conversant with technology, business users press for better information and more sophisticated analytics. End-users are not only more educated about their technology options; they have a greater sense of urgency about information usage. They want to slice and dice data – about share sales, acquisitions and other transactions – to ensure that they can deliver the best rate of return for their investors. And the growing need for unstructured data from email messages and customer relationship systems, among other sources, amplifies the pressure of deploying disparate data to the enterprise. By lessening the administrative burden for IT – the need to learn another operating system, to master another set of configuration techniques, and put together system integration tasks – data warehouse appliances allow IT to focus more on understanding long-term business needs rather than on platforms and machinery. The true value of IT to business users is assisting them in the acquisition of external data, the improvement of data quality, the supporting of data management, the tackling of security and access issues, and other tasks that support the business.

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Steps Involved in the Implementation Unlike other data warehousing solutions, the entire data warehouse appliance solution usually comes in a pre-packaged, preconfigured system. The vision is to create a solution that does not require any complex installation process, database design or administration. The solution is plugged in and the data loaded. Since the goal of data warehouse appliance implementation is to deliver a solution to the business to support an immediate business need, the implementation tasks are less onerous than traditional system implementation tasks. The following example shows the ease with which a data warehouse appliance can be installed to fulfil a business need. A private equity firm, EssCap Investment Partners, has an existing, though small, enterprise data warehouse (EDW) in Oracle that contains information about transactions, the firm’s finances and both target and portfolio companies. Principals and associates both use the EDW to analyse market conditions and data on target companies (see Figure 10.1). Figure 10.1 Typical Data Warehouse that can be used in a Private Equity Firm

Associates

Principals

Oracle database

ETL Data

Portfolio companies

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Transactions

Financial data

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Figure 10.2 Adding a Data Warehouse Appliance, Adding Data

Principals

The addition of data warehouse appliances simplifies and speeds up new processing

Associates

Oracle database

Investor relationship

ETL

Data

Third-party data

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ETL

Data

Portfolio Transactions companies

Financial data

For a crucial club deal, partners of the firm decide to buy an external database on investor relations. The acquisition of data from a third-party provider will help them to see information on investor activity in the entire private equity and hedge fund universe and segment it for their next round of fund-raising. Given that they are buying information owned by a third party, the company won’t own the data but use it for a period of time until they can complete the execution of the club deal. Nevertheless, it turns out that the private equity firm’s data warehouse has become exhausted and can no longer support any new data without an upgrade. When the associates go to IT for help, they are informed that they will not only need to fund an Oracle upgrade, they will need to wait for months due to the IT upgrade backlog of the external consultant that they have retained. Without the right funding – and unwilling to endure the turn­ around time – the principals are frustrated as they do not have the means to get the best out of the investor database, which could result in the loss of millions of dollars in revenue. Figure 10.2 shows how the acquisition of a data warehouse appliance, which can be set up quickly, can provide critical data to the CRM system without affecting the Oracle operations.

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Given that the data warehouse appliance is simpler to set up and install – requiring minimal staff and skills – the associates need to depend on IT to leverage existing extract, transform and load (ETL) skills. And if the company ultimately does invest in an Oracle upgrade, the data warehouse appliance can be ‘repurposed’ to support any number of other business systems. The repurposing of equipment could be an appealing idea to private equity firms trying to get the most out of their IT budgets.

Service-Oriented Architecture Service-oriented architecture (SOA) in private equity is a business-centric IT architectural approach that supports integrating the business as linked, repeatable business tasks or services. Business agility is the buzzword at the IT–business edge and to achieve business agility, an SOA that represents key business processes that are reusable, can be shared and are readily available is being adopted by most private equity firms. The adoption of SOA presents an opportunity to gain additional value from existing IT investments by diverting development endeavours and costs into innovation. Furthermore, SOA shrinks development time and removes the need for a business process reengineering budget. An SOA architectural strategy can support change in dynamic areas of the business, such as regulatory compliance, and the introduction of innovative initiatives. As an architectural approach, it is ideal for designing, building and managing the distributed IT infrastructure that a private equity firm requires to execute and achieve its business strategy and objectives. One of the clear merits of this approach is that it encourages the use of loosely coupled, re­usable, standards-based and well-defined services in a manner that ensures visibility on the network and use by end-users or other applications.

Benefits of SOA ■ Increased agility – The adoption of SOA drives higher levels of reuse and improves response to business demands, market dynamics and increased competition. ■ Maximisation of returns – SOA enables the reduction of complexity and cost of change, and also a reduction in the cost of maintaining diverse environments. ■ Risk mitigation – SOA achieves this through the promotion of security and continuity of business operations as well as the reduction of the impact of technology implementation on people and processes. It also aids in compliance with regulations. ■ Performance improvement – IT’s ability to respond to changing business needs and client satisfaction is improved by the adoption of SOA. It also enhances the linking and extension of the value chain.

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To get the best out of an SOA architecture, private equity firms have to think of business processes as units of work that control and implement business transactions, and SOA services as the building blocks for these business processes. The following are some of the key attributes of SOA services: ■ ■ ■ ■ ■

Independent; Reusable; Shared; Provide a standards-based access interface; Discoverable.

Adoption of SOA promotes the alignment between SOA services and business processes. Proponents of SOA believe that business processes are the drivers of the definition and creation of SOA services, coordination of service execution and invocation of associated services as required. The underlying features of individual SOA services, in response, facilitate the alteration of business processes through the sharing and reuse of services. The benefit, in terms of business agility, is the ability to rapidly adapt and create business processes – such as those that lock relationships into the firm and encourage value creation – and to allow private equity firms to utilise services whose functionality and interfaces are defined to enable the business process.

Comparison of SOA and Traditional Applications When drawing parallels between SOA and traditional applications, the ­evolution of traditional architectures from mainframe time-sharing, clientserver and the web to the current SOA model should first be considered. SOA represents a radical shift from the concepts of traditional application architecture, and a departure from monolithic application architectures and the associated maintenance costs. Having said that, the following table shows a comparison between SOA and traditional applications.

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Traditional applications

Service-Oriented Architecture

Designed to last Tightly coupled Integrated silos Code-oriented Long development cycle Cost-centred Middleware makes them work Favour homogenous technology

Designed to change Loosely coupled, agile and adaptive Compose services Process-oriented Interactive and iterative development Business-oriented Architecture makes it work Favours heterogeneous technology

Source: HP

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SOA and Web Services Web services can be used to implement an SOA but it should be noted that an SOA is not the same as web services. That said, web services are widely used components of SOA implementations since they provide a standardised way of integrating web-based applications, providing a more platform-neutral approach for better interoperability. Web services are software systems designed to support interoperable machine-to-machine interaction over a network. This interoperability is gained through a set of XML-based open standards, such as WSDL, SOAP and UDDI. These standards provide a common approach for defining, publishing and using web services. Platforms such as Java 2 Platform, Enterprise Edition (J2EE) can be used to develop state-of-the-art web services to implement SOA. These kinds of platform enable private equity firms to build and deploy web services in their IT infrastructure on the application server platform. They provide the tools needed to quickly build, test and deploy web services and clients that interoperate with other web services and clients running on Java-based or nonJava-based platforms. Additionally, they enable businesses to expose their existing J2EE applications as web services. Servlets and Enterprise JavaBeans components (EJBs) can be exposed as web services that can be accessed by Java-based or non-Java-based web service clients. J2EE applications can act as web service clients themselves, and they can communicate with other web services, regardless of how they are implemented. Adoption of SOA can help a private equity firm extend the value of web services by providing an architectural scheme that sets the standards and governance model for all business processes, applications and IT infrastructure.

Challenges in Moving to SOA As previously stated, SOA is usually realised through web services. Even if a firm is already using web services, without an SOA framework the growing implementation of web services can create complex business system management problems. Web services’ specifications may add to the confusion of how to best utilise SOA to solve business problems. In order to achieve a smooth transition to SOA, IT managers and developers in private equity firms should be aware that: ■ SOA is an architectural style that has been around for years. Web services are the preferred way to realise SOA. ■ SOA is more than just deploying software. Organisations need to analyse their design techniques, development methodology and agency/client relationship. ■ Moving to SOA should be done incrementally and this requires a shift in how an organisation composes service-based applications while maximising existing IT investments.

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That said, the introduction of an SOA in a firm removes the traditional ­ arriers to business and IT dexterity through architecture, governance, secur­ b ity, manageability, asset reuse, consistency and establishing of standards. In conclusion, for a private equity firm to leverage the benefits of SOA, it has to think of it as a catalyst for improving business results as opposed to hardware, software and protocols. SOA is far from being an off-the-shelf technology; it is an approach for architecting and organising IT and business functionality that can enable a private equity firm to achieve its business goals and effective change management. A well-defined SOA can support multiplatform, diverse technology and environments and accommodate emerging, new and legacy systems and processes that private equity firms can use to leverage existing IT assets and add new functionality as needed with a view to increasing business and IT alignment.

SOA and Web Services Security The loosely coupled nature of SOA and its use of open access via HTTP pose a security challenge for private equity firms. Most companies are reliant on the Secure Socket Layer (SSL) protocol to protect access to SOA deployment. SSL provides the mechanism for authentication as well as confidentiality and message integrity. The snag, however, is when data is not ‘in transit’ and hence unprotected, making the environment vulnerable to attacks in multistep transactions. As a consequence, additional application-level industry standards are required to address the more specific SOA security challenges as follows: ■ Content security: XML Encryption, XML Signature; ■ Message-level security: WS-Security; ■ Secure message delivery: WS-Addressing, WS-Reliable Messaging, WS-Reliable Messaging Policy Assertion; ■ Metadata: WS-Policy, WS-PolicyAssertions, WS-PolicyAttachment, WSSecurityPolicy; ■ Trust management: SAML, WS-Trust, WS-SecureConversation, WSFederation; ■ Public key infrastructure (PKI): PKCS, PKIX, XKMS.

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A number of these standards are not new to the IT security industry; they were originally designed for web applications and later leveraged by SOA. Typical examples are SSL and cross-platform authentication and single signon systems. Other standards, such as WS-Policy, have been created specifically to provide security for networks of web services. In the face of increasing regulatory pressures, SOA deployments are becoming more and more complex, incorporating features such as cryptographic data protection, identity management and governance. This is creating new challenges that developers can no longer meet, given that they are

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used to coding security into web services, creating environment ‘silos’ that are difficult to manage and costly to maintain. SOA security standards meet the objectives of interoperability among ­multiple products used in heterogeneous environments. Thus, standardsbased implementation strategies accelerate development, simplify integration and reduce administration costs over time. Most SOA industry standards are defined in XML frameworks. In recent times, there has been an emergence of a plethora of XML-based specifications addressing various aspects of SOA security. Most of the specifications are part of the so-called WS-* (Web Services Specifications) stack. Most WS-* specifications started as proprietary industry initiatives. Some of these specifications (e.g. WS-Security, WS-Trust, WS-Policy) have been transferred over to standards bodies such as the Organisation for the Advancement of Structured Information Standards (OASIS) or the World Wide Web Consortium (W3C). WS-* specifications often depend on each other; for example, WS-Policy uses WS-PolicyAssertions. WS-* specifications also leverage non-WS specifications; for example, WS-Security uses XML Encryption and XML Signature. (Oracle, 2006) The following is a list of some of the standards that are crucial to the security and manageability of SOA environments: ■ Web Services Security (WS-Security) – This standard specifies SOAP security extensions that seek to ensure confidentiality using XML encryption and data integrity using XML signatures. ■ Web Services Addressing (WS-Addressing) – This provides a transport-neutral mechanism (XML framework) to address web services and messages, identify web services’ endpoints and secure end-to-end endpoint identification in messages. ■ Web Services Reliable Messaging Protocol (WS-RM) – This is a protocol that allows messages to be delivered reliably between distributed applications in the presence of software component, system or network failures. ■ Web Services Policy (WS-Policy) – This provides a general purpose model and corresponding syntax to describe the policies of a web service. It enables the specification of policy information that can be processed by web services applications. ■ Web Services Security Policy (WS-SecurityPolicy) – This defines a set of security policy assertions used in the context of the WS-Policy framework. It can also be described as the standard for ensuring integrity and confidentiality for web services messages. ■ Security Assertion Markup Language (SAML) – This is an open XML-based framework for communicating user authentication, entitlement and attribute information. ■ Web Services Trust (WS-Trust) – This is a WS-* specification that provides extensions to WS-Security, specifically dealing with the issuing, renewing and validating of security tokens, as well as with ways to

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establish, assess the presence of, and broker trust relationships between participants in a secure message exchange. ■ Web Services Secure Conversation (WS-SecureConversation) – Built on top of the WS-Security and WS-Trust models, WS-Secure­ Conversation defines the creation and sharing of security contexts between communicating parties. ■ Web Services Federation (WS-Federation) – This is another component of the Web Services Security model that provides support for secure propagation (across internet domains) by brokering identity, attributes, authentication and authorisation between participating web services.

Adoption of Hardware-based Remote Management

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The private equity business requires principals and associates of the firm to work offsite with the management of portfolio companies that they acquire or invest in and, as a result, they need a new generation of notebook PCs that deliver down-the-wire proactive security, enhanced maintenance and remote management designed right into the chip. This is essential for the protection of clients’ confidential data captured offsite and 24/7 connection to the ­corporate network. IT managers in private equity realise the significance of capabilities that provide security and management for notebook PCs. These capabilities can reduce malicious attacks on PCs and user downtime caused by ­ malicious attacks, problem PCs, maintenance, security updates and application upgrades. Security and management solutions are usually software-based and as a result have posed a challenge for IT support analysts when they try to protect or manage a notebook PC that is powered off, whose operating system (OS) is unresponsive or whose management agents are missing. Notebook PCs with new processor technologies are designed to tackle major issues in security and manageability. This new breed of notebook PCs delivers improved security and management capabilities that are hardwarebased as opposed to software-based. Hardware-based capabilities have advantages over traditional softwarebased solutions in that they allow authorised IT support personnel to remotely access notebook PCs that have conventionally been unavailable to the management console. With these new processor technologies, support analysts are able to manage a notebook PC even in the event of its OS becoming un­responsive, hardware failure, or management agents being disabled. Some new processor technologies are designed to help IT administrators reach more notebook PCs remotely, automate more tasks, perform more work from a remote, centralised location, and reduce user interruptions. The following table shows the benefits of adopting hardware-based remote management.

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Capability

Benefits

Common Uses

Third-party applications check in with hardwarebased timers at IT-defined intervals. A ‘miss’ triggers an event and can send an alert to the IT console to indicate potential problems.

Automated, out-of-band notification of a missing or disabled agent (in combination with policy-based out-of-band alerting)

Security capability Agent presence checking

System isolation Programmable filters check and recovery inbound and outbound network traffic for threats before the OS and application load and after they close down.

■ Monitor inbound/outbound network traffic for threats ■ Identify suspicious packets ■ Quarantine PCs even if agent or OS is disabled

Problem-resolution capability Remote/ redirected boot

Notebook PCs can be remotely booted to a clean state or redirected to another device such as a clean image on local storage, a CD at the helpdesk, or an image on another remote drive.

■ Remote boot PC to clean state ■ Remote watch as BIOS, OS and drivers load to identify problems with boot process ■ Remote build or migrate OS ■ Remote BIOS updates

Console redirection

Console can be redirected to remotely control a PC without user participation.

■ Troubleshoot PC without user participants ■ Remote install missing/ corrupted files ■ Remote hard-drive service or other maintenance

Out-of-band alerting

Policy-based alerts can be received at any time, even if PC power is off, the OS is unresponsive, management agents are missing, or hardware (such as hard drive) fails.

■ Alert on event, such as falling out of combination (in combination with agent presence checking) ■ Alert on thresholds, before component fails

Access to BIOS settings

Allows access to BIOS settings at any time.

■ Correct BIOS settings accidentally managed by user ■ Change settings to solve application conflicts ■ Change PC primary boot device to meet user demands

Source: Intel

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One of the major benefits of these new processor technologies, exemplified by Intel vPro, is the delivery of both out-of-band remote communication built into the notebook PC and robust security technology. This is in contrast to software-only management applications that are, in most cases, installed at the same level as the OS. As a result, management agents are vulnerable to tampering. In the current notebook PC marketplace, software-based communication channels are perceived as having security issues regarding communication privacy. However, the powerful capabilities of new technologies have addressed this issue and ensure that information stored by associates and principals in private equity firms on notebook PCs is well protected. Figure 10.3 Schematic Diagram of Remote Communication with Wireless Systems

Inside the corporate network

Standard wireless communication through the software stack in the OS

All security and remote management capabilities still available

Awake and working properly

Awake but OS is unresponsive

IT console Connected to corporate network through host OSbased VPN

Awake and working properly Some security and remote management capabilities still available

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Commonly Used Terminology This chapter contains a list of commonly used terminology in the private equity industry.

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Introduction The terminology commonly used in the private equity industry, whilst similar to that used in other sectors of the financial services industry, also has its own unique expressions. The terminology is vast and varied as private equity, as seen in earlier chapters, covers a wide range of activities ranging from buyouts to share sales and exits. IT professionals need to be conversant with most of the terms used in the industry to ensure effective communication with their business counterparts. This will also be of increasing importance as IT roles in the future will require a great more business alignment than is currently the case. That said, below are some of the terms used in the private equity ­industry.

List of Terminology ‘A’ round†  A financing event whereby angel groups and/or venture capitalists become involved in a fast-growth company that was previously financed by the founders and their friends and families. Acquisition  This is a process whereby a private equity firm takes over a controlling interest in another company. Acquisition also describes any deal where the bidder ends up with 50% or more of the company taken over. Acquisition finance  This is the form of finance, bank debt and/or equity such as a share issue which private equity firms use to fund an acquisition. Advisory board  An advisory board, less formal than the board of directors, is popular among smaller companies. It typically consists of people, elected by the company founders, whose experience, knowledge and influence can aid the growth and direction of the business. The board will meet periodically but does not have any legal responsibilities with regard to the company. Alternative assets  This is a term used to describe non-traditional asset classes. They include private equity, venture capital, hedge funds and real estate. Alternative assets are, in general, more risky than traditional assets, but they should, in theory, generate higher returns for investors. Anchor LP††  This is an investor in a private equity/venture capital fund that commits a significant amount of the total fund-raising to the fund upfront.

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Asset  Anything owned by an individual, a business or financial institution that has a present or future value, i.e. can be turned into cash. From an accounting standpoint, an asset is something of future economic benefit

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Commonly Used Terminology

obtained as a result of previous transactions. Tangible assets can be land and buildings, fixtures and fittings; examples of intangible assets are goodwill, patents and copyrights. Asset allocation  This is the percentage breakdown of an investment portfolio. This shows how the investment is divided among different asset classes. These classes include shares, bonds, property, cash and overseas investments. Cash has a guaranteed return. Effective asset allocation maximises returns while covering liabilities. Asset stripping††  Dismantling an acquired business by selling off operational and/or financial assets. Auction††  A process in which an investment bank invites several private equity houses to look at a particular company that is for sale and offer a bid to buy it. ‘B’ round†  A financing event whereby investors such as venture capitalists and organised angel groups are sufficiently interested in a company to provide additional funds after the ‘A’ round of financing. Subsequent rounds are called ‘C’, ‘D’ and so on. Balanced fund  This is a fund that spreads its investments between various types of assets such as stocks and bonds. Investors can circumvent excessive risk by balancing their investments in this way. However, they should expect only moderate returns. Beauty parade††  An accepted mechanism for an investee company to select a provider of financial and professional services. The investee normally draws up a shortlist of potential providers, who are then invited to pitch for the business. Benchmark  This is a standard measure used for the assessment of the performance of a company. Investors need information as to whether or not a company is hitting certain benchmarks since this will determine the structure of the investment package. For example, a company that is slow to reach certain benchmarks may compensate investors by increasing their stock allocation. Best efforts offering†  A commitment by a syndicate of investment banks to use best efforts to ensure the sale to investors of a company’s offering of securities. In a best efforts offering, the syndicate avoids any firm commitment for a specific number of shares or bonds. Boat anchor†  A person, project or activity that hinders the growth of a company.

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Bond  A type of IOU issued by companies or institutions. It generally has a fixed interest rate and maturity value, hence it’s very low risk – much less risky than buying equity – but its returns are accordingly low. Bridge loan  This is a kind of short-term financing that lets a company continue running until it can arrange longer-term financing. Companies on occasion make use of this facility because they run out of cash before they receive long-term funding; sometimes they do so to strengthen their balance sheet in the run-up to flotation. Burn rate  This is the rate at which a start-up uses its venture capital funding before it begins earning any revenue. Business angels  Individuals who provide seed or start-up finance to entrepreneurs in return for equity. Angels usually contribute a lot more than pure cash – they often have industry knowledge and contacts that they can pass on to entrepreneurs. Angels sometimes have non-executive directorships in the companies they invest in. Buy-and-build strategy††  Active, organic growth of portfolio companies through add-on acquisitions. Capital call†  This is when a private equity fund manager (usually a ‘general partner’ in a partnership) requests an investor in the fund (a ‘limited partner’) to provide additional capital. Usually, a limited partner will agree to a maximum investment amount and the general partner will make a series of capital calls over time to the limited partner as opportunities arise to finance start-ups and ­buyouts. Capital commitment*  Every investor in a private equity fund commits to investing a specified sum of money in the fund partnership over a specified period of time. The fund records this as the limited partnership’s capital commitment. The sum of capital commitments is equal to the size of the fund. Limited partners and the general partner must make a capital commitment to participate in the fund. Capital distribution*  These are the returns that an investor in a private equity fund receives. It is the income and capital realised from investments less expenses and liabilities. Once a limited partner has had their cost of investment returned, further distributions are actual profit. The partnership agreement determines the timing of distributions to the limited partner. It will also determine how profits are divided among the limited partners and general partner.

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Capital gain  This is the profit realised when an asset is sold for more than the initial purchase cost. This is the opposite of capital loss, which occurs

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Commonly Used Terminology

when an asset is sold for less than the initial purchase price. Capital gain refers strictly to the gain achieved once an asset has been sold – an unrealised capital gain refers to an asset that could potentially produce a gain if it were sold. An investor will not necessarily receive the full value of the capital gain – capital gains are often taxed; the exact amount will depend on the specific tax regime. Capital under management  This is the term used to describe the amount of capital that the fund has at its disposal, and is managing, for investment purposes. Captive firm  This is a private equity firm that is tied to a larger organisation, usually a bank, insurance company or corporate. Carried interest  The share of profits that the fund manager should receive once it has returned the cost of investment to investors. Carried interest is normally expressed as a percentage of the total profits of the fund. Catch-up†  A clause in the agreement between the general partner and the limited partners of a private equity fund. Once the limited partners have received a certain portion of their expected return, the general partner can then receive a majority of the profits until the previously agreed-upon profit split is reached. Clawback*  A clawback provision ensures that a general partner does not receive more than its agreed percentage of carried interest over the life of the fund. So, for example, if a general partner receives 21% of the partnership’s profits instead of the agreed 20%, limited partners can claw back the extra 1%. Closing  This term can be puzzling. If a fund-raising firm announces it has reached first or second closing, this doesn’t necessarily imply that it is not looking for further investment. While in the process of raising funds, a firm will announce a first closing to release or draw down the money raised so far so that it can begin to invest. A fund may have a number of closings, but the typical number is around three. It is only when a firm announces a final closing that it is no longer open to new investors. Co-investment  Even though this term is used loosely for the description of any two parties that invest alongside each other in the same company, it has a unique meaning when referring to limited partners in a fund. Should a limited partner in a fund have co-investment rights, it is able to invest directly in a company that is also backed by the private equity fund. The institution therefore ends up with two separate stakes in the company – one indirectly through the fund; one directly in the company. A number of private equity firms offer co-investment rights to persuade institutions to invest in their funds.

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  The benefit for an institution is that it should see a higher return than if it invested all its private equity allocation in funds – it doesn’t need to pay a management fee and won’t see at least 20% of its return used up by a fund’s carried interest. However, to co-invest successfully, institutions need to have ample knowledge of the market in order to assess whether a co-investment opportunity is a good one. Co-lead investor  Investor who has contributed a similar share with the lead investor in a private equity joint venture or syndicated deal. Company buy-back  The process by which a company buys back the stake held by a financial investor, such as a private equity firm. This is one exit route for private equity funds. Conversion†  The right of an investor or lender to force a company to replace the investor’s preferred shares or the lender’s debt with common shares at a preset conversion ratio. Corporate venturing  This is the term used to refer to a process by which large companies invest in smaller companies. They usually do this for strategic reasons. For instance, a large corporate like Motorola may invest in smaller technology companies that are developing new products that can be assimilated into the Motorola product range. A large pharmaceutical company such as Astra Zeneca might invest in R&D centres on the basis that they get first refusal of research findings. Cram down round†  A financing event in which new investors with substantial capital are able to demand and receive contractual terms that effectively cause the issuance of sufficient new shares by the start-up company to significantly reduce (‘dilute’) the ownership percentage of previous investors. Deal flow†  A measure of the number of potential investments that a fund reviews in any given period. Debt financing  This is a process whereby money is raised for working capital or capital expenditure through some form of loan. This could be by arranging a bank loan or by selling bonds, bills or notes (forms of debt) to individuals or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise to repay the principal plus interest on the debt.

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Distressed debt (otherwise known as vulture capital)*  This is a form of finance used to purchase the corporate bonds of companies that have either filed for bankruptcy or appear likely to do so. Private equity firms and other corporate financiers who buy distressed debt don’t asset-strip and liquidate the companies they purchase. Instead, they can make good returns

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Commonly Used Terminology

by restoring them to health and then prosperity. These buyers first become a major creditor of the target company. This gives them leverage to play a prominent role in the reorganisation or liquidation stage. Distribution in specie/Distribution in kind*  This can happen if an investment has resulted in an IPO. A limited partner may receive its return in the form of stock or securities instead of cash. This can be controversial. The stock may not be liquid and limited partners can be left with shares that are worth a fraction of the amount they would have received in cash. There can also be restrictions in the USA about how soon a limited partner can sell the stock (Rule 144). This means that sometimes the share value has decreased by the time the limited partner is legally allowed to sell. Dividend cover*  A dividend is the amount of a company’s profits paid to shareholders each year. Dividend cover is the calculation used to show how much of a company’s after-tax profit is being used to finance the dividend. The formula is: Dividend Cover = (Earnings per share/Dividend per share). Down round††  Equity financing in a company which values the company at a lower amount/price than in previous financing rounds. Drag-along rights†  The contractual right of an investor in a company to force all other investors to agree to a specific action, such as the sale of the company. Drawdown  As soon as a venture capital firm has decided where it would like to invest, it will approach its own investors in order to draw down the money. The money will already have been pledged to the fund but this is the actual act of transferring the money so that it reaches the investment target. Drawdown schedule†  An estimate of the gradual transfer of committed investment funds from the limited partners of a private equity fund to the general partners. Drive-by VC†  A venture capitalist that only appears during board meetings of a portfolio company and rarely offers advice to management. Dry close (dry closing)*  A dry close is when a private equity firm raises money for a fund early on in the cycle, but then agrees not to levy any management fees on the money raised from its limited partners until it actually begins investing the fund. Most private equity firms will start raising a new fund when their current fund is around 70% invested. Venture firms tend to raise new funds earlier than buyout firms, because they usually need to invest in follow-on rounds for their portfolio firms. Due diligence  In the private equity universe, investing successfully in pri-

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vate equity at a fund or company level entails thorough investigation. Given that it is a long-term investment, it is crucial that a review and analysis of all aspects of the deal are carried out before signing. Areas such as capabilities of the management team, performance record, deal flow, investment strategy and legals are examples of what are thoroughly examined during the due diligence process. Dutch auction†  A method of conducting an IPO whereby newly issued shares of stock are committed to the highest bidder then, if any shares remain, to the next highest bidder, and so on until all the shares are committed. Note that the price per share paid by all buyers is the price commitment of the buyer of the last share. Early-stage finance  This is the speciality of the venture capital – rather than that of the private equity – firm. A venture capitalist will normally invest in a company when it is in an early stage of development. This means that the company has only recently been established, or is still in the process of being established – it needs capital to develop and to become profitable. Earn out†  An arrangement in which sellers of a business receive additional future payments, usually based on financial performance metrics such as revenue or net income. Elevator pitch†  A concise presentation, lasting only a few minutes (an elevator/lift ride), by an entrepreneur to a potential investor about an investment opportunity. Entrepreneur in residence (EIR)  An entrepreneur who has experience in creating a business and who would like to work in a venture capital fund using the fund’s network, deal flow and resources to develop new or existing portfolio companies. Equity financing  Companies intending to raise finance may use equity financing rather than, or in addition to, debt financing. In order to raise equity finance, a company issues new ordinary shares and sells them for cash. The new share owners are now part-owners of the company and share in the risks and rewards of the company’s business. Evergreen fund  A fund in which the returns generated by its investments are automatically channelled back into the fund rather than being distributed back to investors. The purpose is to maintain a continuous supply of capital available for further investments.

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Exit*  Private equity professionals have their eye on the exit from the moment they first see a business plan. An exit is the means by which a fund is able to realise its investment in a company – by an initial public offering, a trade sale,

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Commonly Used Terminology

selling to another private equity firm or a company buy-back. If a fund manager can’t see an obvious exit route in a potential investment, then it won’t touch it. Exiting climates††  The conditions which influence the viability and attractiveness of various exit strategies. First-time fund*  This is the first fund a private equity firm ever raises – whether the firm is made up of managers who have never raised a fund before or, as in many cases, the firm is a spin-off, where managers from different, established funds have joined forces to create their own, new firm. In the first instance, the managers do not have a track record so investing with them can be very risky. In the second instance, the managers will have track records from their previous firms, but the investment is still risky because the individuals are unlikely to have worked together as a team before. Follow-on funding*  Companies often require several rounds of funding. If a private equity firm has invested in a particular company in the past and then provides additional funding at a later stage, this is known as ‘follow-on funding’. Fund age  The age of a fund (in years) from its first drawdown to the time an IRR is calculated. Fund focus  The strategy of specialisation by stage of investment, sector of investment, or geographical concentration. This is the opposite of a generalist fund, which does not focus on any specific geographical area, sector or stage of business. Fund of funds*  A fund set up to distribute investments among a selection of private equity fund managers who, in turn, invest the capital directly. Funds of funds are specialist private equity investors and have existing relationships with firms. They may be able to provide investors with a route to investing in particular funds that would otherwise be closed to them. Investing in funds of funds can also help spread the risk of investing in private equity because they invest the capital in a variety of funds. Fund size  The total amount of capital committed by the limited and general partners of a fund. Fund-raising  This is the process by which a private equity firm solicits financial commitments from limited partners for a fund. Firms typically set a target when they begin raising the fund and ultimately announce that the fund has closed at such-and-such amount. This may mean that no additional capital will be accepted. But sometimes the firms will have multiple interim closings each time they have hit particular targets (first closings, second closings, etc.)

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and final closings. The term cap is the maximum amount of capital a firm will accept in its fund. Gatekeeper  These are specialist advisers who assist institutional investors in their private equity allocation decisions. Institutional investors with little experience of the asset class or those with limited resources often use them to help manage their private equity allocation. Gatekeepers usually offer tailored services according to their clients’ needs, including private equity fund sourcing and due diligence through to complete discretionary mandates. Most gatekeepers also manage funds of funds. General partner  This can refer to the top-ranking partners at a private equity firm as well as the firm managing the private equity fund. General partner contribution/commitment  This is the amount of capital that the fund manager contributes to its own fund. This is an important way for limited partners to ensure that their interests are aligned with those of the general partner. The US Department of Treasury recently removed the legal requirement of the general partner to contribute at least 1% of fund capital, but this is still the usual contribution. Hamster wheel  The situation in a sub-critical mass business with no potential to reach critical mass. It is so-called because the managing director ends up running around getting nowhere and becoming very frustrated. Harvest  This is the term used to describe generating cash or stock from the sale or IPO of companies in a private equity portfolio of investments. Holding period  This is the length of time that an investment is held. For example, if Company A invests in Company B in June 1996 and then sells its stake in June 1999, the holding period is three years. Hostile offer (bid)††  An offer which is made for a target company but which is not recommended for acceptance by shareholders by the board of the target company. Hot money  Capital from investors that have no tolerance for lack of results by the investment manager and move quickly to withdraw at the first sign of trouble.

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Incubator  An entity designed to nurture business ideas or new technologies to the point that they become attractive to venture capitalists. An incubator typically provides physical space and some or all of the services – legal, managerial, technical – needed for a business idea to be developed. Private equity firms often back incubators as a way of generating early-stage investment opportunities.

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Initial public offering (IPO)*  An IPO is the official term for ‘going public’. It occurs when a privately held company – owned, for example, by its founders plus perhaps its private equity investors – lists a proportion of its shares on a stock exchange. IPOs are an exit route for private equity firms. Companies that do an IPO are often relatively small and new and are seeking equity capital to expand their businesses. In-kind distribution†  A distribution to limited partners of a private equity fund that is in the form of publicly trades shares rather than cash. Institutional buyout (IBO)  If a private equity firm takes a majority stake in a management buyout, the deal is an institutional buyout. This is also the term given to a deal in which a private equity firm acquires a company outright and then allocates the incumbent and/or incoming management a stake in the business. Internal rate of return (IRR)*  This is the most appropriate performance benchmark for private equity investments. In simple terms, it is a timeweighted return expressed as a percentage. IRR uses the present sum of cash drawdowns (money invested), the present value of distributions (money returned from investments) and the current value of unrealised investments and applies a discount. J curve†  A concept that during the first few years of a private equity fund, cash flow or returns are negative due to investments, losses and expenses, but as investments produce results, the cash flow or returns trend upward. A graph of cash flow or returns versus time would then resemble the letter ‘J’. Later-stage finance  This is the capital that private equity firms generally provide to established, medium-sized companies that are breaking even or trading profitably. The company uses the capital to finance strategic moves, such as expansion, growth, acquisitions and management buyouts. Lead investor*  This is the firm or individual that organises a round of financing, and usually contributes the largest amount of capital to the deal. Limited partners (LPs)  Institutions or individuals that contribute capital to a private equity fund. LPs typically include pension funds, insurance companies, asset management firms and fund of funds investors. Liquidation†  The sale of a company. This may occur in the context of an acquisition by a larger company or in the context of selling off all assets prior to cessation of operations (Chapter 7 bankruptcy). In liquidation, the claims of secured and unsecured creditors, bondholders and preferred stockholders take precedence over common stockholders.

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Liquidity discount†  A decrease in the value of a private company compared to the value of a similar but publicly traded company. Since an investor in a private company cannot readily sell their investment, the shares in the private company must be valued lower than a comparable public company. Liquidity event†  A transaction whereby owners of a significant portion of the shares of a private company sell their shares in exchange for cash or shares in another, usually larger, company. For example, an IPO is a liquidity event. Lock-up period*  A provision in the underwriting agreement between an investment bank and existing shareholders that prohibits corporate insiders and private equity investors from selling at IPO. Management rights†  The rights often required by a venture capitalist as part of the agreement to invest in a company. The venture capitalist has the right to consult with management on key operational issues, attend board meetings and review information about the company’s financial situation. Market capitalisation†  The value of a publicly traded company as determined by multiplying the number of shares outstanding by the current price per share. Middle stage†  The state of a company when it has received one or more rounds of financing and is generating revenue from its product or service. Also known as ‘growth stage’. Money in  This is a term used to describe a development capital deal where the private equity fund acquires existing shares from the target company, therefore providing it with funds for growth. Money out  This is a term used to describe a development capital deal where the private equity fund acquires existing shares from the business owner. No-shop clause†  A section of an agreement to purchase a company whereby the seller agrees not to market the company to other potential buyers for a specific time period. Orphan†  A start-up company that does not have a venture capitalist as an investor. Overhang  Private equity funds still available for investment in the industry.

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Paid-in capital††  The amount of committed capital an investor has actually transferred to a fund. Also known as the cumulative takedown amount.

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Pari passu†  A legal term referring to the equal treatment of two or more parties in an agreement. For example, a venture capitalist may agree to have registration rights that are pari passu with the other investors in a financing round. Placement agent  Placement agents are specialists in marketing and promoting private equity funds to institutional investors. They usually charge a fee of 2% of any capital they help to raise for the fund. Poison pill††  The most famous anti-takeover device. It normally takes the form of granting existing stockholders (other than stockholders who acquire more than a certain percentage of the company) the option (which can only be exercised upon certain events) to buy more stock on very favourable terms as a way of diluting the position of the person trying to take control. Portfolio at cost  The portfolio at cost is the sum of all private equity and venture capital investments (held at cost) that have been made until the end of the measurement period and that have not yet been exited. Preferred return  This is the minimum amount of return that is distributed to the limited partners until the time when the general partner is eligible to deduct carried interest. The preferred return ensures that the general partner shares in the profits of the partnership only after investments have performed well. Pre-money valuation††  The valuation made of a company prior to a new round of financing. Pre-seed stage  The investment stage before a company is at the seed level. Pre-seed investments are mainly linked to universities and to the financing of research projects, with the aim of building a commercial company around them later on. Private placement  When securities are sold without a public offering, it is referred to as a private placement. Generally, this means that the stock is placed with a select number of private investors. Quasi-equity††  Financing that combines the features of debt and equity. These instruments are unsecured and convertible on exit. Examples are mezzanine finance or subordinated debt. Ratchets  This is a structure that determines the eventual equity allocation between groups of shareholders. A ratchet enables a management team to increase its share of equity in a company if the company is performing well. The equity allocation in a company varies, depending on the performance of the company and the rate of return that the private equity firm achieves.

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Recapitalisation  This term is used to refer to a change in the way a company is financed. It is the result of an injection of capital, either through raising debt or equity. Rights of co-sale with founders†  A clause in venture capital investment agreements that allows the VC fund to sell shares at the same time that the founders of a start-up choose to sell. Right of first refusal†  A contractual right to participate in a transaction. For example, a venture capitalist may participate in a first round of investment in a start-up and request a right of first refusal in any following rounds of investment. Scale-down†  A schedule for phased decreases in management fees for general partners in a limited partnership as the fund reduces its investment activities toward the end of its term. Scale-up†  The process of a company growing quickly while maintaining operational and financial controls in place. Also, a schedule for phased increases in management fees for general partners in a limited partnership as the fund increases its investment activities over time. Search fund††  A fund that is raised by entrepreneurs to find a business, acquire it and manage it until an exit can be achieved. Secondaries  The term for the market for interests in venture capital and private equity limited partnerships from the original investors, who are seeking liquidity of their investment before the limited partnership terminates. An original investor might want to sell its stake in a private equity firm for a variety of reasons: it needs liquidity, it has changed investment strategy or focus or it needs to rebalance its portfolio. The main advantage for investors looking at secondaries is that they can invest in private equity funds over a shorter period than they could with primaries. Secondary buyout  A very popular exit strategy. This type of buyout happens when an investment firm’s holding in a private company is sold to another investor. For example, one venture capital firm might sell its stake in a private company to another venture capital firm. Secondary market  The market for secondary buyouts. This term should not be confused with secondaries.

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Second-lien loan  A loan used in leverage buyouts, which is subordinated to a senior loan (first-lien loan), but has a preferential settlement over a mezzanine loan.

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Second-stage funding  The provision of capital to a company that has entered the production and growth stage, although it may not be making a profit yet. It is often at this stage that venture capitalists become involved in the financing. Seed capital  The provision of very early-stage finance to a company with a business venture or idea that has not yet been established. Capital is often provided before venture capitalists become involved. However, a small number of venture capitalists do provide seed capital. Sequence††  The classification of funds by order of investment. First in a sequence is the new fund, defined as the first fund a management group raises together, regardless of the experience level of individual professionals in that group. Next are follow-on funds, defined as subsequent funds (II, III, IV, etc.), raised by the same management group. Sliding fee scale  This is a management fee that varies over the life of a partnership. Spin-out firms  These are captive or semi-captive firms that gain independence from their parent organisations. Stabled secondary  A deal where a buyer purchases a secondary portfolio, agreeing at the same time to invest in the primary fund being raised by the selling general partners. Strategic investment  An investment that a corporation makes in a young company that can bring something of value to the corporation itself. The aim may be to gain access to a particular product or technology that the start-up company is developing, or to support young companies that could become customers for the corporation’s products. In venture capital rounds, strategic investors are sometimes distinguished from venture capitalists and others who invest primarily with the aim of generating a large return on their investment. Corporate venturing is an example of strategic investing. Syndication  This is the term used to describe the sharing of deals between two or more investors, normally with one firm serving as the lead investor. Investing together allows venture capitalists to pool resources and share the risk of an investment. Takedown†  A schedule of the transfer of capital in phases in order to complete a commitment of funds. Typically, a takedown is used by a general partner of a private equity fund to plan the transfer of capital from the limited partners. Takeover†  The transfer of control of a company.

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Ten bagger†  An investment that returns 10 times the initial capital. Term sheet  A summary sheet detailing the terms and conditions of an investment opportunity. Thin equity  A capital structure in which there is a large amount of debt and very little equity. Tombstone  When a private equity firm has raised a fund, or it wishes to announce a significant closing, it may choose to advertise the event in the financial press – the ad is known as a tombstone. It normally provides details of how much has been raised, the date of closing and the lead investors. Turnaround  Turnaround finance is provided to a company that is experiencing severe financial difficulties. The aim is to provide enough capital to bring a company back from the brink of collapse. Turnaround investments can offer spectacular returns to investors but there are drawbacks: the uncertainty involved means that they are high risk and they take time to implement. Vintage year  This is the year in which a private equity fund makes its first investment. Washout round†  A financing round whereby previous investors, the founders and management suffer significant dilution. Usually, as a result of a washout round, the new investor gains majority ownership and control of the company. White knight††  A company that makes a friendly takeover offer to a target company that is being faced with a hostile takeover from a separate party. Write-off  This is a term used to describe a decrease in the stated valuation of the portfolio company to zero. Write-up  This is a term used to describe an increase in the stated value of the portfolio companies. Zombie†  A company that has received capital from investors but has only generated sufficient revenues and cash flow to maintain its operations without significant growth. Typically, a venture capitalist has to make a difficult decision as to whether to kill off a zombie or continue to invest funds in the hope that the zombie will become a winner.

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† Sourced from ‘Private Equity Glossary’ available from http://mba.tuck.dartmouth. edu/pecenter/resources/glossary.html. * Sourced from www.altassets.com/hm_glossary.ph. †† Sourced from www.evca.eu/toolbox/glossary.aspx?id=982.

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The Future This chapter discusses the future of private equity from both a business and an IT perspective.

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The Future: What does it hold for the Private Equity Industry in Business and IT? In light of what is being observed in the turmoil that has gripped the financial markets in recent times, it will be difficult to predict the future of the private equity industry from both a business and IT perspective. With so much chaos and fluctuation in the market, there have been contradictory guesses as to private equity’s future. Nevertheless, as it is customary for each book in the Bizle Professional Series to close with a discussion of the future of the subject industry, we shall make an attempt at predicting the future of private equity.

Effects of the Credit Crunch on the Private Equity Industry Many industry observers have expressed doubts about the future of private equity in the wake of the global credit crisis, infamously known as the credit crunch.123 This could be the result of the recent cancellation of a number of high-profile private equity deals that have led observers to conclude that the sector is incapable of sustaining its current high level of growth. To accentuate the extent of the doubt, a high-profile newspaper, The New York Times, reported in September 2007 that ‘The private equity gravy train has jumped the tracks’ in an article that reflects the recent conventional wisdom. Another quote from The Times in October 2007, ‘The buyout bubble has burst’, also reflects these sentiments.124 We, along with other industry experts, are of the opinion that this pessimism is unjustifiable. Some observers also assert that in the longer term, the private equity industry will emerge stronger from the credit crunch, as opposed to being hampered by it. In spite of the recent turmoil, the fundamental elements of the private equity business model remain intact. While the credit crunch may have resulted in a reduction in the number of private equity deals, the likelihood that this will hinder the long-term growth of the industry is remote. A 2007 Boston Consulting Group report estimated that the private equity sector will grow by 15 to 20% per year until 2011. We believe that despite the job cuts in the industry in the latter part of 2008, private equity will be still be around for a long time to come. To provide a bit of evidence to justify this conclusion, through 2006 the private equity sector in the USA and Europe accumulated nearly $300 billion in uninvested capital (see Figure 12.1); an indication that there is still a consid-

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123 Private equity in this context is referring to the section of the industry that engages in leveraged buyouts (LBOs). 124 Andrew Ross Sorkin, ‘The Ranks of the Comfortable Are Still Thinning’, The New York Times, 9 September, 2007, and ‘After the Party’, The New York Times, 3 October, 2007.

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Figure 12.1 Diagram Showing that Private Equity still enjoys Ample Access to Capital Funds raised ($billions) 300 ◆ ◆ ◆

200 ◆ 100

◆

◆

Excess capital ($billions)* 300 ◆

◆ 200

◆ 100

◆ ◆

0

1996 1998 2000 2002 2004 2006 1997 1999 2001 2003 2005 United States

Europe

0

◆ Excess capital

Sources: Thomson VentureXpert; Thomson Financial; BCG-IESE analysis. *Excess capital is defined as the cumulative total of funds raised minus funds invested per region.

erable amount of money available for investment. This level of commitment, in terms of capital, will be a potent momentum for future deals. It will also be prudent to quote David Rubenstein, the co-founder of US private equity giant Carlyle, when in 2009 he issued 15 ‘reasons to be cheerful’. These included:125 ■ Private equity capital will be in greater demand than ever going forward, as other sources of capital continue to be available. ■ Spectacular rates of return will be seen in six to nine months, following vendors’ acceptance of the new pricing level. ■ Good opportunities which do not require debt will be attractive. ■ A more measured approach will emerge and the industry will be better for it. ■ Co-investing will make a comeback. ■ Debt will become more available but on terms that require better discipline. ■ There will be less pressure on liability partners to invest quickly. ■ Private equity will be seen as part of the solution by governments global­ly. ■ There will be an increased recognition that private equity in and of itself is not a cause of systemic risk. 125 John Kenchington. (15 February 2009). ‘Carlyle Boss Speaks Out’. City A.M.

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■ Private equity will stabilise and the best-performing companies will continue to grow. ■ It will be seen as the best absolute return model, consistently delivering growth. ■ Private equity will be increasingly less centred on the USA and London. In the midst of the crisis, it was refreshing to learn of the establishment of a new private equity venture in China, called Golden Partners Capital, in February 2009. This firm was created as a result of a link-up between two Chinese giants, China International Capital Corp (CICC), the country’s biggest investment bank, and venture capital business Shanghai International Group (SIG). Industry reports show, at the time of writing, that the Chinese government is encouraging the development of the private equity industry for the fastgrowing country. Private equity is viewed as a new source of capital to prop up the slowing economy, given the reluctance of banks to provide lending and the drying up of the IPO market.

The Growth of Private Equity in Africa Experts have hailed private equity on the African continent as the fastest growing asset and expect this trend to continue for the foreseeable future. The growth of private equity in Africa is estimated to be on a par with Latin America (more on this later) and is expected to triple over the medium term.126 Historically, Africa’s history of economic woes and its political instability have meant it has previously been labelled the ‘hopeless continent’. Despite harbouring some 30% of the world’s gold and almost half of its diamonds and platinum, it has consistently failed to cash in on its enormous wealth of natural resources.127 There has, however, been a sea change in attitudes towards the continent in recent times. There has been a surge in interest in private equity in Africa, mainly as a result of the credit crunch and global asset repricing in Western markets that have prompted investors looking for a higher yield than is obtainable in their markets to search further afield for higher returns and diversification. Sub-Saharan Africa (SSA), in particular, exhibits low correlation to other emerging and developed markets. The African continent, like China and India before it, is steadily doing away with its reputation as a ‘frontier market’ and is becoming a magnet for international private equity funds. Experts buttress this point by comparing Africa’s frontier market status, which has already begun to recede, to that of Brazil,

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126 Moin Siddiqi. (November 2008). ‘Private Equity Flocking to Africa’. African Business. 127 Source: Philip Scott, (16 November 2007), ‘Africa – the final investment frontier’. Available from www.thisismoney.co.uk/invest-in-africa.

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Hungary and Thailand, which were once perceived by institutional investors as ‘exotic’ and ‘forbidding’. Nevertheless, there is a unanimous consensus that Africa is the largest and most exciting market among the frontier markets group. Revenues from natural resources, rising levels of overseas remittances and more business-friendly policies are having a positive impact on Africa, leading to a boom in the financial sector, telecoms, power, housing, health services and beverages. This presents ample opportunities for venture capital and private equity firms to take advantage of growth in expanding markets. A number of experts have taken the view that Africa offers the potential for attractive returns, at significantly lower risk levels than are widely perceived, for direct and portfolio investors. In recent times, the continent has been delivering some exceptional returns. Global investors are increasingly appreciating the fact that risk could come in many different forms. They are aware that risk exists in developed markets that they hadn’t appreciated totally and that there is less risk in Africa than previously thought. The following are interesting statistics from the African Venture Capital Association on private equity in Africa in recent years: ■ Private equity funds for SSA totalled $2.35 billion, up from less than $1 billion in 2005. ■ South Africa recorded the largest amount (at 1.7% GDP), surpassing Europe’s average of 1.5%. ■ South African funds manage over 80% of sub-Saharan PE capital, followed by Nigeria with 10%. ■ SSA’s share of emerging markets private equity funds in 2006 was 7%, a figure comparable to that of Latin America (8%) and Eastern Europe/Russia (10%). As stated earlier, the growth of private equity in Africa is estimated to be on a par with Latin America, where many companies are potential targets for private equity investors. These companies are reported to have strong positions in local markets and are able to benefit from a combination of capital, new ideas and new additions to the management teams. Traditionally, private equity investors had only two ways of generating their profit: 1) by selling their shares back to the family that controlled the company; 2) by selling the whole company to a larger organisation, in most cases a multinational. Of late, there have been rapidly growing local bond markets in a number of Latin-American countries. Local companies that received private equity investment are now able to consider selling bonds. This gives those companies the opportunity to raise enough money to buy out the private equity investors. Therein lies the difference between Latin America and Africa. Experts have identified the following constraints for the different categories in the growth of the African bond market.128 128 Source: Thierry de Longuemar. ‘Unresolved Issues and Challenges of Bond Markets in Africa’; ‘Developing Bond Markets in Emerging Market Economies’. High-level workshop 2007.

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Supply ■ ■ ■ ■ ■

Government remains the main issuer. Treasury issuance is irregular, and volumes are small. Long-term debt instruments are not always available. Small economies lack the critical mass and absorptive capacity. There is the absence of or an illiquid secondary market.

Demand ■ There is a shallow investor base. Commercial banks account for about 70% of outstanding securities debt on average. ■ Non-bank financial institutions are nascent. ■ There is a lack of knowledgeable and skilled market participants. ■ There is no clear-cut strategy to inform and sensitise investors on debt instruments.

Market Infrastructure ■ There is an underdeveloped trading, clearing and settlement infrastructure. ■ OTC trading is predominant, with a lack of up-to-date electronic and IT systems.

Market Information and Transparency ■ There is an absence of set issuance supply calendars. ■ Publication of macroeconomic data and budget plans is untimely. ■ Communication between government and market participants is insufficient. Nevertheless, if all these constraints are eliminated, the private equity industry can truly achieve parity with that of Latin America in the near future. One other key reason for Africa’s promising prospects is that governments across the continent are allowing the private sector to be the engine of growth, encouraging trade, lowering barriers to starting businesses, implementing economic reforms and improving regulatory environments. All these encourage the creation of wealth and this wealth, if responsibly taxed by these governments, can lead to the creation of a revenue stream that can be invested in infrastructure. This kind of development enables a middle class to become established and thrive within a stable society. A burgeoning middle class will demand a myriad of products that entrepreneurial endeavours can fulfil.

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Convergence of Private Equity and Hedge Funds Hedge funds and private equity make natural bedfellows. Readers may recall the distinction made between these two in Chapter 1, but in this chapter the potential for the convergence of the two will be discussed. As hedge funds move into the private equity arena, and private equity funds show up in hedge fund portfolios, some industry experts are of the opinion that the convergence of the two may be a strong possibility for the near future. Customarily, hedge funds and private equity firms have been dissimilar; hedge funds created wealth primarily from publicly traded securities and private equity firms created wealth from private, illiquid equity investments. Recently, however, a number of major hedge funds have been investing in illiquid assets and a number of large capitalisation private equity firms have begun investing in liquid assets. It is this novel hybrid investment model that is leading to the rapid convergence of the space between hedge funds and private equity investments.

Where is the Overlap? Hedge funds and private equity firms are able to compete in three main areas:129 1. The institutional gatekeeper level – where at a number of institutions, investments in alternative assets that encompass both hedge funds and private equity can be undertaken by a single individual or team; 2. At the product level – when private equity fund-of-funds capabilities are mixed with a fund of hedge funds; 3. At the manager level – where managers of hedge funds are increasingly making inroads into private equity territory in the area of distressed lending, where multi-strategy hedge funds have crowded out other players, mezzanine finance, and some of the larger buyout transactions.

Situation in Recent Times The drive for alpha and hedge funds’ relatively large asset base have encouraged hedge fund managers to seek investment opportunities to enhance returns. While the quest for returns is in general accepted as the impetus for the advent of hedge funds’ private equity investments, the outcome of that search and, indeed, the possibility of absolute returns in private equity are not assured.

129 Alan Briefel and Joseph Mariathasan. (2005). ‘Hedge funds and private equity: conflict and convergence?’ Global Pensions.

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Hybrid Investing Hybrid investing is a term used to describe hedge fund investment in both liquid and illiquid assets. Hedge funds undertake hybrid investment through the use of ‘side pockets’. While a side pocket is run by a hedge fund which allocates an amount carved out of its committed capital to invest in illiquid private investment only, it is similar to a conventional private equity fund. There are transfer restrictions in side-pocket investments that are akin to private equity deals, but hedge fund managers of side pockets are less likely to be involved in the company management that is typical of private equity managers. On the other hand, private equity firms get involved in hybrid investing through the creation of hedge fund arms. Side pockets and private equity hedge fund arms have a certain appeal for their managers, given that they enable the managers to leverage their experience in one market to take advantage of inefficiencies in others. In addition, hybrid investing provides firms with a broader base from which to generate returns, and in that way potentially boost profits and decrease risk. This possibility, in turn, has been a draw for investors, who benefit from the additional efficiency of being able to invest in both the private and public markets without the financial and administrative costs of dealing with a hedge fund and private equity firm independently. It is worth noting that combining asset classes and investment strategies, while alluring, can bring about legal issues for investors and the firms alike. There are different rules relating to disclosure, reporting obligations and taxation.

Will Hedge Funds be a Threat to Private Equity Funds in the Future? While it is well known that both hedge funds and private equity firms usually charge a 2% annual fee and receive a 20% share of the profits, there are major advantages that a hedge fund possesses: 1. The calculation of the incentive fees for hedge funds are carried out on a marked-to-market basis, as opposed to private equity firms that only receive this on the realised profits obtained from the actual sale of investments. 2. Private equity firms typically have a hurdle rate of 8% before capital is paid out, which makes hedge fund economies more attractive for the managers.

Conclusion

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and increased competition. This is obviously dependent on the resolution of the current credit crisis. Nevertheless, the convergence of private equity funds and hedge funds will continue in the future.

Increased Investment in Clean Technology As seen in Chapter 7, private equity firms have been investing in clean technology. For the purpose of this discussion, clean technology‘s array of subsectors will be listed as follows: ■ Solar, wind, and geothermal energy generation; ■ Biofuels; ■ Energy storage (power struggle such as batteries and uninterrupted power supplies, or UPS); ■ Nuclear; ■ New pollution-abatements, recycling, clean coal, and water technologies. The private equity industry has undertaken investments in clean technology and energy in buyout transactions – mostly mature companies with high debt capacity in need of strategic change and restructuring; infrastructure – mostly investment in generation assets; and the provision of growth/expansion to companies with revenue streams in need of capital to expand capacity, enter new markets and so on. The credit crunch may, though, have an impact on future investments in this sector. Take wind energy, for instance. Before the credit crunch in 2007, asset finance in clean energy grew by 68%; mature technologies such as wind, solar and biofuels attracted the majority of investment; of all the mature technologies, wind was the one that grew at a faster pace and almost 40% of these investments went to the wind sector.130 Figure 12.2 shows the clean-energy asset finance growth from 2004 to 2007. The effect of the credit crunch has been such that debt spreads increased, on average, by 20–25 basis points in 2008 compared to 2007 (see Figure 12.3). Also, debt finance for large wind portfolio buyout deals has become more difficult to arrange, and banks prefer club deals instead of mandated lead arrangements.131 In recent times, the alignment of political, environmental and economic developments has boosted the clean technology sector. The simultaneous flow of private investment is indicative of gains in critical mass, making it a distinct but small asset class. In the coming years, the sector will be in a situation

130 Peter Dickson. (2007). ‘Trend for Wind Energy Investments’. Fortis Investment. 131 Ibid.

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Figure 12.2 Clean Energy Asset Finance 90

83.9

80 70

USD bn

60

51.1

50 40 26.1

30 20

12.3

10 0



2004

2005

2006

2007

Source: Fortis Investments Clean Energy Fund

Figure 12.3 Change in Wind Project Debt Spreads (bps over LIBOR), 1H07 –1H08 120

113

107 100 80

89 78

60 40 20 0 Europe

US 1H07

1H08

Source: Fortis Investments Clean Energy Fund

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to maintain its momentum in attracting investment as well as building strong exit potential. New technologies will also be introduced to the market. This increased investment is a sign of growing expectations for more widespread adoption of clean technologies – and, of course, the investment returns they are capable of generating. The extent of the commitment of companies – voluntary and otherwise – to the improvement of energy efficiency, the reduction of carbon emissions, and the adoption of technologies that help in the sustainability of clean and affordable water supplies, will be of benefit to current and developing technologies within the clean technologies sector. Industry reports show that there is considerable excitement amongst – and, in large part, as a product of – growing concerns about energy costs, the environment and security. However, it is foreseeable that some technologies will last while others will wane. The achievement of growth in most clean technology companies is a long-lead-time, capital-intensive venture. The push to provide funding for technologies that are unique and can become widely adopted is gathering tremendous pace. The most forward-thinking private equity firms appreciate that clean technologies hold great potential. However, the realisation of such potential requires both specialisation in specific sub-sectors and patience as well as the continued perfect alignment of the factors responsible for bringing clean technologies onto private equity’s radar in the first place.

Increasing Role of Technology The private equity industry will be a more ardent user of technology in the future as it seeks to operate in a radically different marketplace where there will be increased financial regulation and more collaborative deal-making. Newer technologies such as Web 2.0 technologies, which are Web services that let people collaborate and share information online, can be adopted for syndication deals. As private equity IT staff specialise in the acquisition and integration of newly acquired companies into their firm’s portfolios, they will be seriously focused on the application of technology across a broad spectrum of portfolio companies in different industries. Unlike their counterparts at a private or public organisation, who only have to take into consideration how a technology acquisition and implementation will fit within their organisation, private equity IT staff have to consider how a technology implementation might work for all the portfolio companies of the firm. Furthermore, given that the private equity industry is all about deal-making, private equity IT staff will be looking for technologies from vendors that enhance the level of intimacy among the IT staff of the portfolio companies, which can promote synergies among services and technologies they have in common. As IT becomes more integral to the success of the private equity firms, there will be increased outsourcing of their IT operations, given that they are

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more interested in their portfolios and leveraging operations than technology infrastructure. IT security will also become more important as competition begins to hot up in the face of dwindling opportunities. This is because private equity firms will have to keep their transaction information confidential, since there have been occasions when deals have been snatched from private equity firms by other private equity firms and hedge funds after they have completed exhaustive due diligence on the acquisition of a target company.

Conclusion The discussion of the factors that will shape the future of the private equity industry shows how important it is to learn about the business of private equity, and IT professionals that appreciate this importance can forge a fulfilling career in this highly interesting sector of the financial services industry.

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Apax Partners and The Economist Intelligence Unit. (2006). ‘Unlocking global value future trends in private equity investment worldwide’. Available from www.apax.com/Unlocking_global_value_Future_trends_in_private_ equity_investment_worldwide.pdf. Australian Venture Capital Association Limited. ‘How and Why to Invest in Private Equity’. Available from www.avcal.com.au/html/resource/library_ AVCAL_Resources.aspx. Baker, G.P. and Smith, G. D. (1998) The New Financial Capitalists: Kohlberg Kravis Roberts and the Creation of Corporate Value. Cambridge University Press. Baseline Consulting (2005). ‘The Business Case for Data Warehouse Appliances’. Available from www.baseline-consulting.com. Baxon. (2008). ‘Improving Portfolio Management in Private Equity’. Available from www.baxonpe.com. Bierman, H. Jr. (2003). Private Equity: Transforming Public Stock to Create Value. John Wiley & Sons. Blaydon, C. and Wainwright, F. (2003). ‘A Note on Leveraged Buyouts’. ­Centre for Private Equity and Entrepreneurship. Boston Consulting Group and the IESE Business School of the University of Navarra. ‘The Advantage of Persistence – How the Best Private Equity Firms “Beat the Fade”’. Available from www.bcg.com/publications. Briefel A. and Mariathasan J. (April 2005). ‘Hedge Funds and Private Equity: Conflict or Convergence’. Global Pensions. Brown, K. C., Dittmar, A. and Servaes, H. (2003). ‘Corporate Governance, Incentives, and Industry Consolidations’. Draft Paper. Cannice, M. V. (July 9, 2008). ‘Silicon Valley Venture Capitalist Confidence Index’. Available from www.usfca.edu/sobam/nvc/pub/svvcindex.html. Cendrowski, H. et al. (2008). Private Equity: History, Governance and Operations. John Wiley & Sons. Davis Polk & Wardwell. (September 2006). ‘Trends in Private Equity’. A ­Private Equity Perception Study. Delloite. (February 2007). ‘The Big Picture – Private Equity Trends’. Available from www.deloitte.com/dtt/cda/doc/content/UK_CF_PETrends_Feb07. pdf. Dickson, P. (2008). ‘Trends for Wind Energy Investments’. Fortis. EDS. ‘How Information Technology Changes in a Private Equity World’. Viewpoint Paper. Ernst and Young. (2006). ‘How do Private Equity Investors Create Value’. A Study of 2006 Exits in the US and Western Europe. Available from www. ey.com/global/content.nsf/International/Transactions_-_Private_equity_ study_2008. Euromoney Institutional Investor PLC. ‘The Nature of Private Equity’. Euro­ money Books.

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Fort Washington Capital Partners Group. (September 2006). ‘Investing in Private Equity through a Fund of Funds’. Available from www.fortwashington. com/includes/InvestinginPEPaperUpdated0609.pdf. Franklin, R. and Hugo, E. (June 2007). ‘Venture Capital Innovation and IT’. Library House. Freshfields Bruckhaus Deringer. ‘Take Private Transactions in the UK’. Available www.altassets.com/pdfs/freshfields-takeprivate.pdf. Gadiesh, O. and MacArthur, H. (2008). Lessons from Private Equity Any Company Can Use (Memo to the CEO). Harvard Business School Press. Hickey III, T. A. and O’Brien Radford, R. ‘Convergence: The Buzzword for Hedge Funds and Private Equity Funds in ’06’. Kirkpatrick & Lockhart Nicholson Graham LLP. International Financial Services London. (April 2008). ‘Sovereign Wealth Funds 2008’. Available from www.ifsl.org.uk. International Financial Services London. (August 2008). ‘Private Equity 2008’. Available from www.ifsl.org.uk. Jenkinson, T. (2007). ‘How is Private Equity Changing Public Equity Markets?’ Saïd Business School, Oxford University. Kelly, J. (28/11/2007). ‘The hybrid capacity: The Convergence between Hedge Funds and Private Equity Firms’. Nixon Peabody LLP. Ladley, J. (2005). ‘New Technologies for Top CIO Challenges’. Knowledge and Information Solutions. Lamb. K. (2008). ‘Cashing in on the Venture Capital Cycle’. Available from www.investopedia.com. Lambert, G. D. (2007). ‘Private Equity Opens Up for the Little Investor’. Investopedia. de Lavenère Lussan, J. (22 December 2008). ‘Madoff offers an extremely expensive lesson in due diligence’. Privateequitywire. Leeds, R. and Sunderland, J. (Spring 2003). ‘Private Equity Investing in Emerging Markets’. Journal of Applied Corporate Finance. Volume 15 Number 4. pp 8–9. de Longuemar, T. ‘Unresolved Issues and Challenges in Bond Markets’. Developing Bond Markets in Emerging Market Economies High-Level Workshop 2007. Makower, J. Pernick, R. and Wilder, C. (March 2005). ‘Clean Trends 2005’. Cleanedge. McDowall, R. ( 20 Aug 2007 ). ‘TheTech Requirements of Private Equity’. Available from www.silicon.com/financialservices/0,3800010322,39168203,00. htm. McKnight, W. (2005) ‘A Fresh Look at Data Warehouse Technology: Introducing the Data Warehouse Appliance’. A McKnight Associates, Inc. White Paper. Meyer, T and Mathonet, P-Y. (2005). Beyond the J Curve: Managing a Port­ folio of Venture Capital and Private Equity Funds. John Wiley & Sons. Monash, C. A. (August 2007). ‘Index-Light MPP Data Warehousing’. A Monash Information Services Bulletin.

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Northern Trust. (2006). ‘Gaining Access to Private Equity’. Piper Jaffrey’s. (August 2003). ‘Alternative Assets – Private Equity Fund of Funds’. Special Report. PricewaterhouseCoopers and National Venture Capital Association. (April 2008). ‘Cleantech Comes of Age’. Findings from the MoneyTree Report. PricewaterhouseCoopers. ‘Seeking Differentiation at a Time of Change’. ­Global Private Equity Report 2008. Private Equity Council.(2007). ‘Public Value: A Primer on Private Equity’. Available from www.privateequitycouncil.org. Probitas Partners. (July 2005). ‘The Guide to Private Equity Fund Investment Due Diligence’. Private Equity International. Raden, N. (March 2005). ‘Solving the Load/Query Conundrum in Dimensional Design’. Hired Brains Inc. Service Employees International Union (April 2007). ‘Behind the Buyouts: Inside the World of Private Equity’. Available from www.behindthebuyouts.org/media-center/2007/4/24/new-seiu-report-inside-the-world-ofprivate-equity.html. Service Employees International Union (April 2008). ‘Sovereign Wealth Funds and Private Equity; Increased Access, Decreased Transparency’. Available from www.behindthebuyouts.org. Société Générale. ‘Private Equity Index’. Available from http://uk.warrants. com. SPA Exchange Traded Funds. (2007). ‘Exchange Traded Funds’. Selftrade. Available from www.selftrade.co.uk. State Street. ‘State Street Private Equity Index’. Available from www.statestreet.com/analytics/SSIA_pei.pdf. The eFinancialCareers.com. ‘Careers in Financial Market in Europe 2008/09’. Available from www.efinancialcareers.com/students. The European Private Equity and Venture Capital Association. (May 2005). ‘Industry Snapshot’. EVCA Barometer. The European Private Equity and Venture Capital Association. (November 2007). ‘Guide on Private Equity and Venture Capital for Entrepreneurs’. Special Paper. Venture Capital Investment Firms. (2008). ‘The History of Venture Capital’. Available from www.venturecapitalinvestmentfirms.com/history-venturecapital. White, C. (August 2005). ‘Using a Multi-Tier Data Warehouse Appliance to Age Data Gracefully’. I Research. Winter, R. (2005). ‘Data Warehouse: New Requirements Lead to New Approaches’. Winter Corporation. Wylie, A. (2006). ‘The Rise of Private Equity Real Estate Funds’. International Investors.

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Index 3i Group plc profile  53–54 ‘A’ round  154 acquisition finance  154 acquisitions definition  154 exits for venture investments  86, 120 advisers private equity market  37–38 venture capital funds  85 advisory board  154 Africa private equity growth  172–174 agents  37–38 AltAssets  56–57 alternative assets  4, 16, 154 see also hedge funds; private equity; real estate; venture capital anchor LP  154 Asia Pacific private equity market  44 asset definition  154–155 asset allocation  155 asset stripping  9, 155 auction  155 ‘B’ round  155 Bain Capital Inc case study of buyout of KB Toys  71– 72 profile  54 balanced fund  155 banks comparison with venture capital firms  87–88 role in private equity fundraising  97 beauty parade  155 benchmark  155 best efforts offering  155 biofuels see clean energy biotechnology see life sciences and biotechnology boat anchor  155 bond  156 Brazil

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private equity market  110 see also Latin America bridge financing  29, 89, 156 burn rate  156 business angels  18, 156 business plan preparation by investee company  115 scrutiny by private equity firm  122 buy-and-build strategy  156 buy-in management buyout (BIMBO)  64–65 buy-ins  29 buyouts  5, 29, 38, 62–74 10 largest transactions  63 buy-in management buyout  64–65 leveraged buyout (LBO)  68–71 management buy-in  64 management buyout  62–63 meaning  62 roll-up transactions  66–68 take private transactions  65–66 types  62–66 capital call  84, 156 capital commitment  84, 156 capital distribution  8, 27, 156 capital gain  8, 27, 156–157 capital under management  157 captive firm  157 Carlyle case study of buyout of Hertz Car Rental  72–74 profile  51–52 carried interest  27, 87, 157 case studies Bain buyout of KB Toys  71–72 Carlyle/Calyton Dubilier & Rice buyout of Hertz Car Rental  72–74 catch-up  157 China private equity market  109, 110, 172 clawback  157 clean energy private equity investment  110–111, 177–179 closing  157 co-investment  24, 37, 157–158

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co-lead investor  158 company buyback  158 company seeking private equity finance negotiation process  116–118 procedures  114–121, 129 selection of firm  116 conversion  13, 158 corporate venturing  83–84, 158 cram down round  158 credit crunch effect on private equity  170–172

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data providers  54–58 AltAssets  56–57 European Venture Capital Journal (EVCJ)  56 FINalternatives  57 The Financial Times  55 The Journal of Private Equity (JPE)  57–58 Library House Ltd  57 MoneyTreeTM Report  56 Private Equity Insider  58 Private Equity International  54–55 Reuters Professional Publishing  55 data warehousing appliances  140–145 deal flow  114, 158 debt financing  158 disbursements venture capital firms  85 distressed debt  6, 158–159 distribution in specie  159 divestment  5, 27 dividend cover  159 dividend recapitalisation  74 Bain buyout of KB Toys case study  71–72 Carlyle/Calyton Dubilier & Rice buyout of Hertz Car Rental case study  72–74 down round  159 drag-along rights  159 drawdown  10, 159 drive-by VC  159 dry close  159 due diligence hedge funds vs private equity  19 investor’s perspective  124–128 Madoff fraud scandal  127–128

meaning  159–160 private equity firms’ perspective  118 Dutch auction  160 early-stage finance  81, 89, 160 earn out  160 economy private equity market, effect on  49–50 elevator pitch  160 emerging markets private equity investing  108–110 energy, investments in  6 see also clean energy entrepreneur in residence (EIR)  81, 160 environment see clean energy equity financing  160 Europe private equity market  43–44 European Venture Capital Journal (EVCJ)  56 evergreen fund  160 exchange-traded funds (ETFs) definition  100 operation  100–101 private equity ETFs  99, 101 exit meaning  160–161 venture capital firms  86, 120–121 exiting climates  161 fee structure  14–15 FINalternatives  57 The Financial Times  55 first-time fund  161 follow-on funding  161 fraud Madoff scandal  127–128 fund age  161 fund managers investor’s evaluation  124–125 key skills  122–123 relationship with investors  127 selection in portfolio construction  32 fund of funds  26, 85 benefits  99 definition  98, 161 popularity  97–99 private equity real-estate funds  106– 108

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fund size  161 fund-raising meaning  161–162 private equity firms  5 venture capital firms  84 gatekeeper  85, 162 general partner  7, 37, 162 general partner contribution/ commitment  162 geography diversification in portfolio construction  32 global private equity market  42–45 glossary  154–168 growth capital definition  5 hamster wheel  162 harvest  162 hedge funds comparison with private equity  18– 20 management fees  20 possible convergence with private equity  175–176 relationship with private equity  97 Hertz Car Rental case study of Carlyle/Calyton Dubilier & Rice buyout  72–74 high potential company (HPC) characteristics  8–9 hostile offer  162 hot money  162 hurdle rate  27 in-kind distribution  163 incubator  162 India private equity market  109, 110 indices Private Equity Index (Privex)  59–60 Silicon Valley Venture Capital Confidence Index  59 Street Private Equity Index  60 industry diversification in portfolio construction  32–33 private equity investment  39 venture capital-backed sectors  89–93

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information sources see data providers infrastructure, investments in  6 initial public offering (IPO) definition  163 roll-up transactions  67 venture capital firms  86, 121 institutional buyout (IBO)  163 internal rate of return (IRR)  3, 27, 163 investee companies see portfolio companies investment banks see banks investors due diligence process  124–128 private equity market  36 IPO see initial public offering Islamic private equity  101–102 IT data warehouse appliances  140–145 hardware-based remote management  150–152 list of systems  137 portfolio management  134–137, 179–180 private equity firms’ strategy  50 requirements of private equity funds  132–137 service-oriented architecture (SOA)  145–150 target sector for venture capital  90– 92 virtual data room (VDR) systems  133 J curve  163 The Journal of Private Equity (JPE)  57–58 KB Toys case study of Bain buyout  71–72 Kohlberg, Kravis Roberts & Co (KKR)  69 profile  51 later-stage finance  82, 89, 163 Latin America private equity growth  173 lead investor  163 leveraged buyout (LBO)  29, 68–71 Bain buyout of KB Toys case study 71–72 Carlyle/Calyton Dubilier & Rice buyout of Hertz Car Rental case study  72–74

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definition  5 dividend recapitalisation  74 history  69 operation  68–69 preferred equity  70–71 risk  70 theory  69–71 Library House Ltd  57 life sciences and biotechnology target sector for venture capital  93 limited partners (LPs)  7, 15, 27, 37, 163 limited partnerships private equity fund structure  36–37 liquidation  121 definition  163 liquidity discount  164 liquidity event  164 loan capital  13 lock-up period  164 Madoff, Bernard  127–128 management buy-in (MBI)  64 venture capital  76 management buyout (MBO)  62–63 venture capital  76 management fees hedge funds vs private equity  20 private equity firms  15 venture capital funds  87 management rights  164 market capitalisation  164 mergers exits for venture investments  86, 120 mezzanine capital definition  6 Middle East private equity in the MENA region  102–103 middle stage  164 money in  164 MoneyTreeTM Report  56 no-shop clause  164 North America private equity market  42–43

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ordinary shares  13 orphan  164 overhang  164

P2P transactions  65–66 paid-in capital  164 pari passu  165 placement agent  38, 165 poison pill  165 politics private equity market, effect on  49 portfolio at cost  165 portfolio companies  4, 7 business plan  115 size  30 portfolio construction private equity investments  31–33 portfolio management IT role  134–137, 179–180 power, investments in  6 see also clean energy pre-seed stage  165 preference shares  13 preferred equity leveraged buyout (LBO)  70–71 preferred ordinary shares  13 preferred return  165 private equity advantages over senior debt  16–17 as an alternative investment  16 banks’ role in fundraising  97 benefits  15 business model  6–8 clean energy  110–111, 177–179 comparison with hedge funds  18–20 concept  2–4 controversy  9–10 credit crunch implications  170–172 data warehouse appliances  140–145 definitions  4 disadvantages  15–16 divestment  5, 27 emerging markets  108–110 facts  14 fund-raising activities  5 the future  170–180 glossary of terms  154–168 hardware-based remote management  150–152 history  10 indices  59–60 investment activities  5 Islamic  101–102 MENA region  102–103

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possible convergence with hedge funds  175–176 rationale for investing in  10–11 real-estate funds  105–108 relationship with hedge funds  97 sector specialisation  30–31 service-oriented architecture (SOA)  145–150 size of investee company  30 sovereign wealth funds  104–105 transparency issues  10, 133–134, 140 trends  96–111 types  5–6 versus self-financing  18 versus stock market flotation  18 private equity exchange-traded funds (ETFs)  99, 101 private equity firms 3i Group plc  10, 53–54 Bain Capital Inc  54 Carlyle  51–52 classes of share and loan capital  12– 13 consortia  96–97, 140 due diligence process  118 fee structure  14–15 investment process  122–123 investments of interest to  12 IT strategy  50 Kohlberg, Kravis Roberts & Co (KKR)  51 limited partnership structure  36–37 list of largest firms  21 management fees  15 procedure for company seeking finance from  114–121, 129 relationship with investee company  119–120 TPG Capital  52–53 private equity funds captive  25 categories  38–39 diversification in portfolio construction  31–33 financing phases of a company’s development  28–29 fund of funds  26, 85, 97–99 independent  25 IT requirements  132–137 monitoring by investors  126–127

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real-estate fund of funds  106–108 secondary market  33 semi-captive  25–26 specialisation  28 Private Equity Index (Privex)  59–60 Private Equity Insider newsletter  58 Private Equity International  54–55 private equity investment categories  38 majority vs minority size debate  29– 30 operation  27–28 portfolio construction  31–33 primary means  24–25 risk levels  26 types of funds  25–26 private equity managers see fund managers private equity market Africa  172–174 agents and advisers  37–38 Asia Pacific  44 Brazil  110 China  109, 110, 172 country analysis  39, 41–45 economy, effect of  49–50 environmental factors  49–50 Europe  43–44 India  109, 110 intermediaries  36–37 investor types  36 issuers  37 Latin America  173 North America  42–43 politics affecting  49 regulation, effect of  49 Russia  109–110 size of global market  40–45 structure  36–38 private placement  165 public to private (P2P) transactions  65– 66 quasi-equity  165 ratchets  165 real estate investment in  6 private equity real-estate funds  105– 108

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recapitalisation  166 regulation private equity market, effect on  49 rescue investments  29 Reuters Professional Publishing  55 right of first refusal  166 rights of co-sale with founders  166 risk dividend recapitalisation  74 leveraged buyout (LBO)  70 roll-up transactions  66–68 initial public offerings  67 Russia private equity market  109–110

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scale-down  166 scale-up  166 search fund  166 second-lien loan  166 second-stage financing  89, 166 secondary investments definition  6, 166 secondary market  166 private equity funds  33 venture capital partnerships  84–85 sectors private equity specialisation  30–31 venture capital-backed operations  89–93 security hardware-based remote management  150–152 service-oriented architecture (SOA)  148–150 seed financing  28, 37, 81, 88, 167 senior debt advantages of private equity over senior debt  16–17 sequence  167 service-oriented architecture (SOA)  145–150 security issues  148–150 web services  147 share capital  12 Shari’ah law Islamic private equity  101–102 Silicon Valley Venture Capital Confidence Index  59 sliding fee scale  167 sovereign wealth funds

private equity  104–105 spin-out firms  167 stabled secondary  167 start-up financing  28, 29–30, 37, 81, 88 venture capital  37, 77, 88 stock market flotation  18, 121 see also initial public offering (IPO) strategic investment  167 Street Private Equity Index  60 syndication  167 take private transactions  65–66 takedown  167 takeover  167 technology see clean energy; IT; life sciences and biotechnology telecoms industry target sector for venture capital  92 ten bagger  168 term sheet  168 Texas Pacific Group see TPG Capital thin equity  168 tombstone  168 TPG Capital profile  52–53 trade sales see acquisitions; mergers transparency private equity  10, 133–134, 140 turnaround investments  29, 168 venture capital  37, 76–94 definitions  5, 77–78 funding  88–89 history  79–80 investing  78 IT sector  90–92 life sciences and biotechnology industry  93 list  94 telecoms industry  92 use of term in Europe vs USA  76 venture capital firms capital calls  84 carried interest  87 commitments  84 comparison with banks  87–88 corporate venturing  83–84 disbursements  85 exits from investment  86, 120–121

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Appendix

fund-raising  84 initial public offering (IPO) as exit  86, 121 mergers and acquisitions as exit  86, 120 structure  77, 80–81 types  83 venture capital funds illiquidity  84 management fees  87 secondary partnerships  84–85 valuations  86–87, 121 venture capitalists characteristics  77, 80–81 investment focus  81–82

length of investment  82 meaning  78–79 vintage year  32, 168 washout round  168 web services service-oriented architecture (SOA)  147 use by private equity industry  179 white knight  168 wind energy see clean energy write-off  168 write-up  168 zombie  168

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Appendix

About the Bizle Brand The Bizle brand represents the model approach to brand extension. This brand stands for excellence, quality, vision and innovation.

Innovation

Excellence

Bizle

Quality

Vision

Bizle can be extended to any product that is related to fostering education, especially in the alignment of IT with business, such as the following: ■ ■ ■ ■ ■ ■ ■ ■ ■

Training materials Training sessions E-learning tools such as CBTs Business Software Conferences and Seminars Magazines Boot camps Certification programmes Online Portals such as the www.bizle.biz

At Essvale Corporation Ltd, we have a great vision for leveraging the Bizle brand equity and are looking for partners who share this vision that can ensure that the brand fulfils its global potential. For further information on the Bizle Brand and to inquire about a potential partnership arrangement, please contact us on [email protected]. *Bizle is a protected trademark

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for IT Professionals

Business Knowledge for IT in Private Equity

www.bizle.biz The First Online Portal Dedicated to the Alignment of IT and Business

Bizle is going to be the premier online portal dedicated to the alignment of IT and business and promotion of professionalism in IT. Bizle is going to be a business and social networking site for both IT and business professionals as well as students. Using Web 2.0 technology, this portal will be an interconnected network of IT and business people from around the world.

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Appendix

Useful Websites Belgian Venture Capital & Private Equity Association

www.bva.be

British Venture Capital Association

www.bvca.co.uk

Business Partners

www.businesspartners.com

Canada’s Venture Capital & Private Equity Association

www.cvca.ca

Capital IQ

www.capitaliq.com

China Venture Capital Association

www.cvca.com.hk

European Venture Capital Association

www.evca.com

FT in Depth – Private Equity

www.ft.com/indepth/privateequity

Growing Business

www.growingbusiness.co.uk

Indian Venture Capital and Private Equity Association

www.indianvca.org

Japan Venture Capital Association

www.jvca.jp

The British Business Angels Association (BBAA)

www.bbaa.org.uk

Malaysian Venture Capital and Private Equity Association

www.mvca.org.my

New Zealand Venture Capital Association

www.nzvca.co.nz

National Venture Capital Association (US)

www.nvca.org

Private Equity Council

www.privateequityonline.com

Private Equity Week Wire

www.pewnews.com

PrivateEquityCareers

www.privateequitycareers.net

The Australian Private Equity & Venture Capital Association

www.avcal.com.au

Russia Private Equity and Venture Capital Association

www.rvca.ru

South Africa Venture Capital Association

www.savca.co.za

Taiwan Private Equity & Venture Capital Association

www.tvca.org.tw

TheDeal.com

www.thedeal.com/newsletter/ wire_register.html

The Irish Venture Capital Association

www.ivca.ie

Tornado-Insider.com

www. Tornado-Insider.com

VentureXpert Web

www.venturexpert.com

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Business Knowledge for IT in Private Equity

Other Titles in the Bizle Professional Series

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Business Knowledge for IT in Global Investment Banking

Business Knowledge for IT in Pharmaceuticals

Business Knowledge for IT in Commodities

Business Knowledge for IT in Foreign Exchange

Career Guidebook for IT in Investment Banking

Business Knowledge for IT in Mobile Telecoms

These and other exciting titles can be pre-ordered on Amazon sites worldwide or on www.essvale.com.

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