Private Equity : An Overview

Professor Eli Talmor

September 2011
Institutional Private Equity Has
Become a Distinct Asset Class

 $2.5 trillion asset under management

and committed capital (“dry powder”)
 20 largest public US pension funds have $111 billion in
PE on behalf of 10.5 million beneficiaries

 Growth and value investments across a

wide range of industries
 Investments in all stages of corporate
lifecycle

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Compared with public equities, PE
outperformed

Source: Bain & Company (2010) 3

UK Private Equity Performance vs. Principal
Pension Comparators to December 2010

Source: BVCA, Capital Dynamics & PWC Annual Performance Measure Survey, August 2011
4
UK PE Performance since inception
by vintage year to December 2010

Source: BVCA, Capital Dynamics & PWC Annual Performance Measure Survey, August 2011
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Academic evidence on private
equity performance

 “There is a general consensus across different

methodologies, measures and time periods
regarding a key stylized fact: LBOs and
especially MBOs enhance performance and have
a salient effect on work practices.” Cumming,
Siegel, Wright (2007)

 Caveat – public-to-privates appear to be

different

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From an esoteric player in the early 80s
to a leading market force today

 4270 private Equity Funds

 25% of global M&A
 50% of leverage loan volume
 33% of high-yield bond market
 30% of initial public offerings market

Morgan Stanley, Triago, Preqin

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 Private Equity Penetration (2009–2010)

Annual private equity investment as percentage of GDP

1.20
1.13

1.00
0.90

0.80
PE Investment/GDP (%)

2009

0.63
2010
0.60 0.57

0.43 0.44

0.40 0.34
0.32
0.26
0.23
0.21
0.20 0.16 0.16
0.13 0.11
0.10
0.06 0.08 0.06 0.06 0.08
0.06
0.04 0.04
0.02 0.01 0.01 0.01 0.01 0.01
0.00
United United Israel India Brazil China Russia Poland SSA South Japan MENA Mexico South Turkey
Kingdom States Korea Africa

© Emerging Markets Private Equity Association. Data as of 31 December 2010. Published 25 August 2011. 8
Quoted stocks vs. private equity

 The three pillars of public equity

markets
 Non predictability of returns
 Diversification
 No Arbitrage

 All three are violated in Private Equity

 Persistence of Returns
 Larger, illiquid investments
 All forms of Arbitrage: Governance,
Regulatory, Leverage, Tax
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What is PE?

In what to invest?
Who invests?
What percentage?
Illiquidity?
Fund structure, horizon
Hands on, involvement
Strategic?
 Legal Structure (1)

 Investments in private equity are

typically non quoted
 Predominant organization form is the
limited partnership structure
 5-10 (+1+1) year horizon, then self
dissolving.
 Limited partnerships consist of limited
partners (LP) and general partners (GP)

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Legal Structure (2)
INVESTORS/ LIMITED
PARTNERS
(Capital)

MANAGER/
GENERAL PARTNER
(Expertise) FUND

PORTFOLIO COMPANIES

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What do the investors get?
 Their investment back

 All profits up to an agreed level

 Known as the “preferred return” or “hurdle”
 Requires GP to outperform less risky investments
 Typically 8% compounded per annum on commitments
drawn down but not yet repaid

 80% of any profits in excess of the hurdle

 Usually, once GP has “caught up” preferred return

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 What does the GP get?

 Management fee (annually)

 Around 1.2-1.5% for megafunds
 Typically 1.5% - 2% for mid-market buyout funds
 Up to 2.5% for venture funds and emerging market funds
 Carried interest
 Form of performance fee
 Typically 20% of the fund’s net profits
 Only paid once investors have received a minimum return
 Deal by deal (a US system) or at fund level profit level (a
European system)
 Trans fees for corp. fin. activities (1-1.5% of EV)
 Return on co-investment interest

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Private Equity Invests at All Stages of
the Corporate Life Cycle

Seed/Start- Expansion Liquidity Event (e.g.,

up Capital IPO, Strategic Sale, etc,)
Follow-on Bridge/
Venture Mezzanine
Buyout Distressed
Financing

Concept Development Later Stage Reengineering/

Stage Stage Restructuring

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Private Equity vs. Venture Capital

 Except for the dot com years, international

“Venture Capital” dominated by buyouts
(LBOs)
 restructuring, MBOs
 Expansion Capital
 companies relatively big and old

 Confusing Terminology:
VC (Eur., Asia, Afr.) = Private Equity (US)

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 Alternative Assets Class
7 – 10 Angel
years Investors
Early
Stage Buyout
Venture Firms

3–7
years Growth
Equity
Time to
Liquidity
Late Stage
Active / Venture
Distresse
1–3 d Assets
years HF

Passive
Hedge
Quarterly Funds

Small % 10 - 35% 35 - 50% 50 -75% 75-100%

Ownership stake
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 Private Equity Value Chain: 5 steps
Screeni Executin Adding Harvesti
Sourcing
ng g Value ng

Finding the Evaluation Getting it Build economic Money back

deals done value
Angle  Re-cap?
- Proprietary Nail the due …within the
WHYTB: key  IPO
deal flow? diligence business
issues for  Full sale
- Auction (legal, fin., Organic
strategic DD) -
processes IT, HR, growth - Trade sale
Financing insurance,
Have M&A
package etc.)
- - Secondary
investment - Strategic buyout
Theses Fit All
the repositioning /
• Specific Assess elements in divestment
sectors chance to win place …through the
• Size - Equity financing and
• Geography - Structured the final sale
Debt process
- Regulatory
sign off?
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Winning PE firms need differentiated
investment capabilities

Source: Bain & Company (2010)

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Diametrically Opposite Investment
Strategies

KKR Fidelity

Companies Held* 60 Over

7,000

Board Seats 100% 0%

* September 2011
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Private equity has transformed the
DNA of corporate governance

 A small “workshop” board concentration of

ownership and control

 Focus on exit / short time horizon

 High power compensation »» self selection of

managers

 Alignment of incentives

 Expectations are not managed by financial

analysts

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Private Equity Firms Can Attract the
Best Investing Talent

 Flexibility
 Compensation
 Carried interest
 Ability to create high profile brand

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The Upper Quartile Syndrome

$160
Average Distributions by Year

$140

$120

$100
$ in Millions

First Quartile
$80

$60

$40
$45 mln
All Other
$20

$0

90 92 94 96 98 00 02 04 06

Source: Venture Economics

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 Performance Persistence: Are there good
GPs? Yes!

Next Time Tercile High likelihood that the next

funds of a partnership stays
in the same performance
Bottom Medium Top bracket
Bottom
Tercile 61% 22% 17% Persistence
 At the top and bottom
Medium
Tercile 25% 45% 30%  Persistence for top quartile
funds remains even in
market downturns!
Top Tercile 27% 24% 48%

Source: Kaplan and Schoar, 2005

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Risk and Diversification

 Precise standard deviation is practically impossible to

measure
 However strong evidence on risk reduction through
asset allocation

1 Long term horizon 30 years, short term horizon 19 years.

2 Long term horizon 24 years, short term horizon 16 years.

Source: NVCA

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Diversification Gains of Private Equity
Allocations

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Private Equity within Asset Allocation

Source: HarbourVest
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Private Equity Increasingly Raising
Investor Capital at the Retail Level

 Fund of funds lower minimum investment

for smaller investors or provide diversity,
access, management for larger investors

 Incremental level of “fees for

management”

 Alternatively, to buy listed funds:

Blackstone, Apollo, Ripplewood, Carlyle,
etc.

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 UBS Four Main Pillars for PE
Portfolio Diversification

Vintage North America

years 2007, Vintage Geography Europe
2008, 2009 Asia
& 2010
Diversified
Private
Equity
Range of
Portfolio
managers in Venture Capital
each geography, Manager Strategy Buyout
strategy and Growth Capital
vintage Special Situation

Source: UBS Marketing Presentation (2006)

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