Private Equity samenvatting MSc F&I PDF

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Lecture 1Handout 1 - Private Equity OverviewPrivate equity fund types VCo Early stageLarge info asymmetryValue in intangible assetsoMinority stake --> equity /mezzanine BuyoutoMajority stakeo Loans (bank/bonds)o Political issuesMezzanine debto Finances LBO's --> subordinated debto PIK not...

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Lecture 1 Handout 1.1 - Private Equity Overview Private equity fund types  VC o Early stage  Large info asymmetry  Value in intangible assets o Minority stake --> equity /mezzanine  Buyout o Majority stake o Loans (bank/bonds) o Political issues  Mezzanine debt o Finances LBO's --> subordinated debt o PIK notes with Equity warrants --> equity/debt like risk-return profile  Distressed o Distressed-to-control (loan-to-own) --> Debt --> hope for equity during restructuring/bankruptcy o Turnaround --> Invest in Debt or Equity VC stages  Seed capital --> Idea  R&D --> Prototype  Start-up --> Pre-operational --> product development and market testing  Early stage expansion --> operational --> real business with fte's, equipment, WC  Late stage expansion --> growing sales, WC  Pre-IPO --> sustainable growth, WC and multiple products PE stages (seller, mgmt) - risk high-to-low  Turnaround --> desperate shareholder --> N  Replacement capital --> family shareholder --> O  Institutional buy-out --> Orphan asset --> N + O  Management buy-in --> Orphan asset --> N  Management buy-out --> Orphan asset --> N + O PE view of risk  Low-risk --> diversification --> 2008? High dry powder, few deals…  Nice CF after 2y PE Fundlife  Fundraising o Roadshow & marketing --> fund closed after admitting LPs  Pledged/committed capital --> Capital calls  Once committed --> LPs share in risk/reward --> no fund involvement  Success --> business cycle, investment strategy, past performance/credentials  Investing o Deal sourcing and execution (3-5y) o Only during inv. Period --> GP can call money from LP  Harvesting o Deal exit and profit distribution (5y)

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Investments held 3-7y --> possible fund extension Proceeds distributed in cash or shares (kind) --> waterfall

PE fees 

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Fixed Mgmt. fee --> 2% annual --> on pledged or deployed capital o Phased out during exits o Conflict of interest --> deploy more capital or postpone exits Carried interest o 80/20 profit after hurdle rate --> ratchets occur (first I get 8%) o Computed as %share profits or deal-by-deal (1-2% deal value)

Returns 

J-curve. Neg during portfolio construction, upwards during value creation and harvesting

Origin of success  Selective buying  long-term tracking, deep DD  Driving the business plan  high involvement  bring in management and specialists o Grant management 5-10% equity  Exit well --> long-term planning --> preparation process, warm up the market Exit routes  Strategic buyer o Pro

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High price Complete exit Efficient auction process Only 1 regulatory constraint: competition authority

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Management replaced Negotiating to competitors

Con

Financial buyer o Complete exit, efficient process, no comp neg, but lower price IPO o Sort of exit, no management replaced o Con  No complete/timely exit  Not highest price (unless best exchange/hot sector)  Market dependent  Long expensive and regulated, also post-IPO Leveraged recap (take loans to issue dividend, lever up company) o Pro  no management replacement o Con  credit market dependent, requires high CF, investor still in control, leverage limits flexibility

2008-2011 PE  Fundamentals as value driver  Asset protection / cash saving  low investment activity  decreasing valuations  Growth in buyout fund activity  Regulators demand transparency and accountability  fair value vs investment at cost 2012-2016

Record fundraising and capital concentration  High asset prices  High returns PE works with low interest rates 2016-2019  Fundraising declining, further capital concentration  more capital chasing deals  lower returns  P2P deals  Decline in interest rates  

2019-present  Hot PE industry, record volume and size  Outlook; supply chain disruptions, inflationary pressure, rising rates..

Handout 1.2 - Fund Formation & Organization Basic Fund structure  LPs (limited (risk) partner) --> commit capital to a fund, provide capital if called for  GPs (general partner) --> make capital calls; execute entry, management and exits; multiple funds (new funds 3-5y after last fund close)  GP/LP agreement Setting up in NY  Easy to set up - no regulations due to sophisticated investors  London is totally different; requires authorization  Ideal environment: fiscal incentives for exits, LPs LT perspective

LECTURE 2 Handout 2.1 - financial statements Assets & Liabilities  Equity investments  minority stake in others  Minority interest  minority stake in OUR subsidiary  Goodwill = purchase BS equity – old BS equity + financing fee’s  acquisition premium o Impairments not tax-deductible (don’t reward poor performance)  DTA/DTL  if tax profits < book profits  add delta to DTL o DTA = NOLs * t Income statement  EBITDA/EBIT  independent of capital structure  clean CF proxy  NOPLAT  uses actual cash paid to tax authorities, leaving out deferred tax o NOPAT = NOPLAT without deferred taxes CF statement (practice 2.1)  Operations o Net Income o + D&A o – delta NWC (current assets and accounts payable)  Investments o Capex (end vs beg fixed assets + depr)  Financing o Debt / stock / dividends

Handout 2.2 - Discussion on value and invested capital Profitability first  Profit growth rate = P(N) / P(O) -1 = ROIC * RR  Reinvestment rate = Reinvested capital / P(O)  ROIC = Future extra profits / Extra invested capital Measuring returns - ROE  ROE = Net income / common equity o Pros  simple o Cons  Capital structure  no operational/financial distinction, account distortions  ROIC = NOPAT / Capital Invested

o o

Pros  Independent of Capital structure, measure of economic value/performance  book value as base year ROIC to multiples  book to market values, CF proxy, Switch around

LECTURE 3 Handout 2.2 – FV examples Firm Value  Multiples are essentially the price of its cash flows. FV/EBIT multiple of 11 means that each dollar of CF is priced at 11$ in the market.

Telecom overview  What drives multiple differences? o Growth perspective (market position, entry barriers, client concentration) o Risk (leverage/economic/political)

Handout 2.4 - comparable based valuation Why do we do comps?  Analyzing comparable companies (similar operating, financial, and ownership profiles)  Provide relative valuation of public companies, proxy for private companies, soon-to-be listed companies  Comps are used to compute investment returns, or to validate DCF assumptions Public comps - selection criteria  Industry / company specifics o Incl. small font; use broker research reports for industry multiple ranges  Company size (financials) o Small companies valued differently o Indexing might distort valuation  Geography  Liquidity and shareholder concentration o Lack of liquidity distorts valuation (liquidity discount, liquidity risk)  Exclude outliers  Lawsuits, M&A rumours  Conglomerate trading statistics o Conglomerates often trade along its largest/strongest growth business Public comps - issues to consider  Normalize & calendarize financials (one-offs, fiscal year)  Compute diluted shares  Different share classes, Options, Stock splits, Stock issued after last financials (treat proceeds as cash + #stocks)  Accounting rules (used to vary) How do we do comparables valuation? 1. Select companies based on operations (geography), financials (size), ownership profile (DLOM, DLOC) 2. Compute multiples 3. Assess which multiples make sense for the sector 4. Assess difference in stage of development, growth prospects 5. Compute implied value for target (using historicals and the multiple) 6. Consider other discounts/premiums (market share, customer base, market entry, life cycle of sector) FV multiples:  FV/Sales  FV/EBITDA  FV/EBIT  FV/Net PP&E  FV/subscribers Equity multiples  P/E

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P/CF P/BV

Which multiples (equity or FV) are better?  FV/EBITDA o Eliminate capital structure o Undistorted by NC items and tax rates o Difficult to compute o Used for M&A, PE investments  P/E o Depends on capital structure o Distorted by NC items and tax rates o Simple to compute o Used for banks and passive investing  can’t alter capital structure, current ROE important

Section 2.0 - Precedent transaction multiples Example 1A  Find the precedent transaction multiple o 80% for 542m USD --> you purchase 80% of shares, thus 542/0.8 = 677.5 equity value Example 2A  Find the precedent transaction multiple o 93.32% at 119m USD --> 119/0.9332 = 127.5 equity value Precedent transaction comparables  100% acquisition  Acquirer will assume all liabilities  "amount paid" might or might not include debt in this case..  Exclude 90% What impacts the price paid (in multiples)  Financials  Synergies  Industry  Geography  Leverage  Deal process  competitiveness  % stake  Liquidity and shareholder concentration  Market share / customer concentration / market size What have we done so far?  Compute ROE, extend to ROIC, replace BV with MV, replace NOPAT with EBIT, Flip it

Lecture 4 Handout 4.1 - leveraged buyouts Modigliani-Miller

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Firm value is independent of financing o Doesn't hold due to taxes, costs of financial distress, information asymmetry

Boat analogy  Business is like a boat with 1. management, 2. credit, 3. subordinated credit, 4. convertible lending, 5. pref. equity, 6. common equity --> sinking boat will make equity holders rock the boat and incentivize management --> equity holders want a party in a boat, so put rocks on other side (debt) and increase ROE ROE and ROIC  ROE = ROIC + (ROIC - i*) * (D/E) o i* = after-tax cost interest rate (cost of debt) = (1-t)*i o ROE = (EBIT-i*D) * (1-t) / E o ROIC = (EBIT*(1-t))/(D+E) o i = interest rate o NOPAT = EBIT (1-t) Macro scale  ROE = ROIC + ROIC (ROIC- i*)*D/E  Dow jones index = GDP growth + (GDP growth - interest rate) * total debt/total equity o Total equity = market cap public + private companies How does leverage create value?  Interest expense is tax deductible  Debt is cheaper than equity What is a good LBO candidate?  Business fundamentals o Base business o Management o Fixed asset quality  easy leverage o FCF generation  Market characteristics o Fair relative valuation o Few potential interlopers o Receptive shareholder base  avoid blocking positions Key factors of debt capacity  Industry o Industry/product life cycle o Capital intensity / Fixed assets o Regulation  Company o FCF and FCF stability  Operating cash flow = EBITDA – NWC changes - CAPEX o Fixed asset quality o Operating track record o Size o Competitive advantages o Supplier / Customer / Product / Geographic concentration Leverage structure

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Total debt 5x EBITDA Bank debt  50% High yield debt  25% Equity  25% Subordination  contractual or legal structure (further away from CF, get leftovers)

LBO modelling tasks  Operating model  down to EBIT  Insert net capital structure  Assume exit multiple  Plug in required return  get transaction price  Asymmetry in value perception to enhance returns  roll-over equity, seller notes, sponsor credit participation Pro forma balance sheet  Write up/downs  Equity wiped out  replace by purchase equity – TC  Cash and investments wiped out  replace by new cash  both wiped in M&A model  Debt wiped out  replace by new debt  both wiped in M&A model  Add intangibles + financing fee Uses of funds  Purchase price of equity  based on multiples, expectations, and premia  Financing fees  Capitalize on goodwill  Transaction fees  expensed  Retirement of existing debt  must be paid off due to covenants  repayment costs Sources of funds  Debt  Old cash and investments  New equity Knowledge required  Debt capacity, deal structure, equity contribution (plug) New equity structure must  ensure control, mitigate risk, incentivize mgmt, achieve returns Pro-forma of ownership  Overview of equity holders ownership %  Based on newly invested equity, rolled over equity, management incentives

LECTURE 6 Valuation methodologies  Comparable company analysis  Precedent transaction analysis  DCF analysis (intrinsic value)  highest value  LBO/recap analysis  lowest value  Other (liquidation analysis, sum-of-the-parts, discounted future share price, expected IPO, historical trading performance, EPS impact, DDM)

Handout 5.2 - PE auction process Preparation and pre-marketing - phase 0

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Budget & mid-term business plan preparation Collection process for dataroom preparation Internal legal DD Internal Financial & tax DD - Vendor assistance, normalizing accounts External financial & tax DD - vendor DD (VDD) Drafting info memo & teaser End with teaser and NDA distribution

Preparation of Information Memorandum  Selling/marketing document  Heavy on advisors (takes about 3 months)  Exec summary, investment highlights, strategic development, macro overview, market overview, products/brands, company overview, sales/distribution/production, corporate support, financial information Marketing - phase 1 (4-6 weeks)  Distribution of info memo and phase 1 process letter (how bid should be presented)  Continue with data room prep  Finalize financial & tax DD (external) and VDD report  Start prep management presentation  Preparation of audited/IFRS accounts  End with receipt of non-binding bids Opening bid contents:  Purchase price and deal teams for x% share (cash and debt-free basis: firm value, but assuming that there is no cash/debt)  Strategic considerations  Which legal entity acquires Investment process - phase 2  Selection of buyers moving forward; distribution of phase 2 process letters  Distribution of VVD reports  Finalization of management presentations and rehearsals  Management presentation to biddeers  Start of DD and Q&A process  Expert sessions  Internal drafting of SPA and disclosure letter  (Distribution of draft SPA)  End with receipt of binding bids Investment process - phase 3  Selection of who proceeds  Distribution of draft SPA and disclosure letters  Price and other SPA negotiations  Preparation of anti-trust filing  Obtain all internal approvals  Secure external debt financing  Finish by signing the SPA Post SPA signing - phase 4  Anti-trust filing  Obtain all internal approvals (bidders)

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Obtain all external approvals (anti-trust) Fulfill all remaining conditions (sellers) Finish by closing (money/shares exchange)

SPA purpose  Buyer o o o o o 

Title to shares All conditions precedent Protective covenants Protection on liabilities Out clause (cancel without penalty)

Seller o o o

Transaction certainty Limit exposure and timing on liabilities/warrants Out clause

SPA  IDSCCCBSSIE  Introductory  Date and parties  Definitions and interpretations  Sale & purchase clause  who sells what to whom  Consideration  price (cash/stock) and adjustments o Completion accounts  FV debt-and-cash free o Locked box  Equity value  Conditions  Financing, reg/shareholder approvals, out-clause, squeeze-out  Covenants  conditions between signing and closing o Seller’s obligations  business continuity, inform buyer, access to management, MAC o Consequences  Seller's representations (warranties)  Guarantees / list of facts to ensure accountability  Buyer's representations (warranties)  Guarantees  e.g. Approval to proceed, no law violations, valid company  Survival of warranties  timeline for representations’ validity  Indemnities (compensation)  for representations and covenants, undisclosed liabilities  Escrow  considerations in an escrow account

LECTURE 7 - PP Handout 6.2 - Equity PP calculation & pricing adjustments Equity price calculation - Rationale  M&A  per share price needed as shares exchange hands  Business value derived from: o Performance  Financials  Multiple o Balance sheet  WC and operating assets to achieve performance + Non-operating assets (adjustment required) Equity price adjustments/calculation  Not required  P2P / No fixed assets  Value paid = equity value price per share o Pros  Simple (no pricing adjustment) / No liability recourse / Value gap between signing and closing

Pricing adjustments  NMWTC  WC  Cash and debt free basis under normal WC Level required to justify EBITDA o Firm value derived off EBITDA  assumes 0 net debt and adequate WC/operating assets o Buyer pays for CASH, seller pays for DEBT  from FV to equity value  Net Debt  Interest bearing debt, accrued interest, Capital/Finance leases – free cash and equivalents/securities  Minority Interest  other stakes in your subsidiaries  Capex/Marketing  Control Capex spend to avoid cash extraction (business starving)  completion account only  Taxes  receivables/payables treated as cash/debt  DTA/DTL = cash/debt if certain Maybe bucket  Buyers  TCRP  Tax balances and accruals until completion  Pension deficits  Capex underspend  Restructuring costs Worth a try bucket  Buyers  Future Capex  Deferred tax balances  Prepayments (subscriptions)  Contract break fees  Capitalized operating leases Working capital  Current assets  Account receivable / inventory / prepayments / Other  Current liabilities  Account payable / Deferred revenues / Other  Buyer wants high Normal WC  Seller wants low Normal WC o Buyer gets compensation for shortfall  First determine reference value and bandwidth in case of 'ordinary business'  base on historicals  requires distortion / one-off adjustments  Second determine WC differential  buyer receives discount if WC is too low Pricing adjustment summary

Working capital / Capex  Only negative adjustments  FV + WC – normal WC

Completion/Lockbox methods Completion accounts (CA) timeline  Pre SPA signing  DD, negotiations, SPA drafting  SPA signing  price in SPA listed as cash and debt free FV and associated price adjustments  Closing  PP paid to seller, Risk & Benefit switches to buyer  Seller takes risk for price adjustments until closing, buyer takes it afterwards and seeks protection on risk items between signing/closing through pre-completion covenants (as final price unknown yet)  Accounting policies setout in NDA to avoid disputes  specific policies referring to a benchmark and subject to the relevant accounting principles Two steps  Purchase price goes in 2 steps. First, at closing, we run the analysis on available May financials. Second, we wait until June and redo the analysis, resulting in a top-up or top-down. Leakage  permitted dividends/management fees

Lockbox procedure  Price calculation on historical financials  Buyer’s risk and economic benefit after reference/locked box date  both parties know what they get (equity price determined)  useful if hostile  Buyers prefer lockbox  cheaper price (financial control before legal control = free CF)  No need to protect Capex and marketing adjustments  no incentive, cause cash in next statements are irrelevant..  Permitted leakage  deviations from ordinary business agreed upon during negotiations  avoids cash extractions

Pro's LB vs CA (seller)  Pro's o Price visibility (certainty, compare bids) o Simpler process, potential cost savings (no completion adjustments, balance sheet agreed upon) o Better control over sale process o Competitive process forces bidders to be less demanding and more DD completed  Con's o Give up CF (unless agreed on sharing these) o Unfamiliarity by buyers due to new approach o Difficult in carve-outs (limited balance sheet availability) Pro's LB vs CA (Buyer)  Pro's o Price visibility (certainty) o Simpler process, potential cost savings (no completion adjustments, balance sheet agreed upon)

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Receive CF benefit due to locked box date

Con's o o o

No buyer power ...