Private Equity Firms

The typical private equity firm is organized as a partnership or

limited liability corporation.
The PE firm raises equity capital through a PE fund.
Most PE funds are “closed-end vehicles in which investors
commit to provide a certain amount of money to pay for
investments in companies as well as management fees to the
private equity firm.
The PE funds are organized as limited partnerships in which
the general partners manage the fund and the limited partners
provide most of the capital.
Limited Partners- institutional investors, insurance cos,
wealthy individuals.
General Partner- PE Firm
 Types of Private Equity:

Leveraged buyout (LBO)

Venture capital
Growth capital
 Leveraged Buyouts (LBO)
A leveraged buy-out (LBO) is an acquisition of a public or
private company in which the takeover is financed
predominantly by debt with minimum equity investment.
The acquisition is carried out by a specialized investment firm.
These firms are referred to as private equity firms.
The PE firm buys majority control of the company it has
acquired.
The debt includes a combination of bank loans, loans from
other financial institutions and high-yield bonds.
Assets of the acquired company act as collateral for the debt
and interest and principal obligations are met through cash
flows of the refinanced company.
 Venture Capital
VC is a type of private equity capital typically provided to
early-stage, high-potential, growth companies in the
interest of generating a return through an eventual
realization 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.
Venture capital typically comes from institutional
investors and HNW individuals and is pooled together by
dedicated investment firms.
 Growth capital
Refers to equity investments, most often
minority investments, in more mature
companies that are looking for capital to
expand or restructure operations, enter new
markets or finance a major acquisition without
a change of control of the business
These companies are likely to be more
mature than VC funded companies, able to
generate revenue and operating profits but
unable to generate sufficient cash to fund
major expansions, acquisitions or other
investments. 
 LBO
The acquisition by a small group of investors of a public or
private company, financed primarily with debt.
“Taking the company private.”
Shares in “pure” LBO no longer trade on the open market.
There have been some public LBOs called leveraged
recapitalizations.
For most LBOs, remaining equity in the LBO is usually
privately held by a small group of investors (usually
institutional, or management).
A large fraction of debt that finances LBO transactions tends to
be “junk” debt
Cont…
 LBO Criteria
Steady and predictable cash flow
 Divestible assets
Clean balance sheet with little debt
Strong management team
 Strong, defensible market position
Viable exit strategy
 Limited working capital requirements
Synergy opportunities
Minimal future capital requirements
Potential for expense reduction
Heavy asset base for loan collateral
 Industry Players
The 10 largest private equity firms in the world are:
The Carlyle Group (US)
Goldman Sachs principal Investment area (US)
TPG
Kohlberg Kravis Roberts (US)
CVC capital partners (European)
Apollo Management
Brain Capital (US)
Permira (European)
Apax partners (European)
The Blackstone Group (US)
 Typical LBO Transaction Structure
Offerings Percent Of Cost Of Lending Likely Source
Transaction Capital Parameters

Senior 50-60% 7-10% •5-7 years payback •Commercial banks

Debt •2.0x -3.0 •Credit companies
EBITDA •Insurance
•2.0x interest companies
coverage
Mezzanine 20-30% 10-20% •7-10 years Public market
Financing payback Insurance companies
•1.0-2.0x EBITDA LBO/mezzanine
Funds
Equity 20-30% 25-40% 4-6 years exit •Management
strategy •LBO funds
•Subordinated debt
holders
•Investment banks
 Valuation
Market Comparison :
These are metrics such as multiples of revenue, net
earnings and EBITDA that can be compared among public
and private companies
 A discount of 10% to 40% is applied to private companies
due to the lack of liquidity of their shares.
Discounted cash flow (DCF) analysis:
An appropriate discount rate is used to calculate a net
present value of projected cash flows.
Option Approach :
Using put call parity equation
 Exit Strategies
Exit Strategy Comments

Sale Often the equity holders will seek an outright

sale to a strategic buyer, or even another
financial buyer

Initial Public Offering While an IPO is not likely to result in the

sale of the entire entity, it does allow the
buyer to realize a gain on its investment

Recapitalization The equity holders may recapitalize by re-

leveraging the entity, replacing equity with
more debt, in order to extract cash from the
company
 Advantage
Independent future development of the company,
Management best knowing the business and its
potential,
Conducting business in a more simple and efficient
manner,
Tax shield,
Flexible structure of financing (various manners of
accomplishment),
High potential yield of investment in LBO.
 Disadvantage
1. Bankruptcy risk –
Excessive debt financing, comprising about 97%
of the total consideration
Large interest payments that exceeded the
company's operating cash flow
2. Leverage can induce firms to choose overly risky
projects
Over-optimistic forecasts of the revenues of the
target company
Example
 Example
 Firm can take on one of two projects, project A or B.
 Project A can pay off either $50 or $150, each
with probability 1/2.
Project B always pays off $110.
Neither project costs anything to invest . NPV of
project A is $100, NPV of project B is $110.
 Project B is higher NPV and should be chosen.
 However, suppose that the firm has pre-existing,
outstanding debt with fact value of $100. Which
project will the owners of the firm choose?
 Cont…
If choose project B, payment to shareholders will be $10
with certainty, after paying off debt.
 If choose project A, shareholders receive $150 -$100 =
$50 in good state, which occurs with prob. 1/2 ==>
shareholders receive expected value of $25.
Owners would choose project A, the riskier one (and
Lower return), gambling with “other people’s money”
i.e. “bag the bondholder.”
 Problem with LBO
Rising interest rates
Higher asset valuation - overpayment
Political backlash
More regulation of Industry
“US private equity shaken by revelation of price collusion
probe” October 11, 2006
Economic slowdown
Failure of exit strategy

18
 The LBO Deal of Tata & Tetley
Summer 2000, Tata Tea acquired the UK heavyweight brand
Tetley for a staggering 271 million pounds .
This deal which happened to be the largest cross-border
acquisition by any Indian company,
Objective :
 Aggressive growth and worldwide expansion.
Instant access to Tetley’s worldwide operations,
combined turnover at Rs 3000 crs
The major challenge was financing
The value of Tata tea was $114m
Tetley was valued at $450m
The solution was provided by Leverage Buy Outing the deal
 Finance
Tata Tea created a Special Purpose Vehicle (SPV)-christened
Tata Tea (Great Britain) to acquire all the properties of Tetley.
The SPV was capitalised at 70 mn pounds, of which Tata tea
contributed 60 mn pounds; this included 45 mn pounds raised
through a GDR issue.
The US subsidiary of the company, Tata Tea Inc. had
contributed the balance 10 mn pounds.
The SPV leveraged the 70 mn pounds equity 3.36 times to
raise a debt of 235 mn pounds, to finance the deal
The tenure of debt varied from 7 years to 9.5 years, with a
coupon rate of around 11% which was 424 basis points above
LIBOR.
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