AFIN808 CORPORATE FINANCE

WEEK 8
VENTURE CAPITAL AND PRIVATE EQUITY

PRIVATE EQUITY
NOT LISTED ON STOCK EXCHANGE
ACCESS CAPITAL FROM
A POOL OF LARGE INVESTORS
GOOD OR BAD?
EX ANTE AND EX POST CAPITAL

PRIVATE EQUITY
Categories and Players
Angel
Early Stage: Seed, Start-up

Professional Venture Capital

Early Stage, Expansion, Later Stage

Private Equity
Later Stage, Buyout, Special Situations

Hedge Funds
All Stages

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The Private Equity Market

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Key Player Overlap

Venture Capital

Private Equity

Angel

Hedge Funds

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The publicly held corporation has Agency costs:
separation of ownership from control
a dispersed ownership structure
Jensen [1989] that publicly held corporation eclipsed
by a relatively new organisational structure:
equity is privately held with peak tier
management having a significant equity stake
that the firm is highly leveraged
there is an active investor in the form of
private equity institutions

PRIVATE EQUITY
PE firms represent an innovation in capital markets.
The PE fund is usually set up as a limited partnership
the funds have an exit strategy with aim of
maximising returns in terms of fees and dividends
received- but main source of return will be the exit
value generated
exit tends to take place 3-5 years after the buyout
exit occurs in a variety of ways trade sales, IPO,
or re-IPO.

Private Equity Partnership

Investment Phase

Payout Phase
General Partner get carried
interest in 20% of profits

General Partner put up

1% of capital
Mgmt fees
Limited
partners
put in 99%
of capital

Partnership

Partnership

Limited
partners get
investment
back, then 80%
of profits

Company 1
Investment in
diversified
portfolio of
companies

Company 2
Sale or IPO of
companies
Company N

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The Limited Partners providing
most of the capital and the
General Partners making
investment decisions and
receiving a substantial share
of profits (most often 20%)
A conflict: General Partners have skills in
identifying and managing potentially profitable
investments, but have to rely on external capital
provided by limited partners to finance these
investments. The
GPs have limited liability and take less of the
downside risk they have an incentive to
overstate the quality of investments when trying
to raise finance.

PRIVATE EQUITY

2 regimes:
GP raises capital on a deal-by-deal
basis (ex post financing)
GP raises a fund which can
completely finance a number of
future projects (ex ante financing)

PRIVATE EQUITY

With ex post financing debt is

optimal form of financing GPs
undertaking all investments they
can get financing for. Whether
deals are financed depends largely
on the state of the economy
overinvestment in good times and
underinvestment in bad times.

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With ex ante financing tying compensation

of GP to collective performance of fund the
GP less likely to invest in bad deals; can
minimise tendency of GPs to shift risk to
debt by giving investors a debt claim plus a
levered equity stake. Downside leaves GP
with substantial freedom once has the
capital can fund deals, even in bad times.

PRIVATE EQUITY
Growth in PE accompanied by increasing criticism.
accused of
asset stripping and profiting from reselling
of assets within a short period of time
restructuring with negative impact on
employment and employee remuneration
using leverage to reduce tax
- threat of increased regulation
Are they good or bad still debating. There
have been a few waves, with different
economic backgrounds

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What problems does PE resolve?
incentive alignment
augmentation of the market for control
Optimal to use a mix of ex ante and ex post
capital.
Giving the GP some capital ex ante preserves
his incentives to avoid bad deals in good times,
but adding the ex post component has the
effect of preventing the GP from being able to
invest in bad deals in bad times. Ex post deal
funding is done with risky debt that has to be
raised from third parties.

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From GLOBAL PRIVATE EQUITY REPORT 2013

From GLOBAL PRIVATE EQUITY REPORT 2013

From GLOBAL PRIVATE EQUITY REPORT 2013

From GLOBAL PRIVATE EQUITY REPORT 2013