Private Equity Lbo

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 Transaction Capital

Lending Parameters

Likely Source

Senior Debt

50-60%

•5-7 years payback •2.0x -3.0 EBITDA •2.0x interest coverage •7-10 years payback •1.0-2.0x EBITDA

•Commercial banks •Credit companies •Insurance companies

4-6 years exit strategy

•Management •LBO funds •Subordinated debt holders •Investment banks

7-10%

Mezzanine 20-30% Financing

10-20%

Equity

25-40%

20-30%

Public market Insurance companies LBO/mezzanine Funds

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 releveraging 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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