Part I: The Rationale behind Private Equity
financing
Why more and more investors allocate money to PE funds rather
than traditional vehicles or securities like mutual funds and stocks? Is PE
less risky than Mutual Funds? Of course not. So why this behavior? What makes
wealthy individuals and big institutions accept to wait 10 to 12 years before
receiving any of their returns? Why they accept to give a proxy to managerial
teams to minister their funds and in the same time are keen to forgive almost
all their monitoring power over these funds? The answer could only be that the
investment is worth the waiting time, the lost of power and the risk taken. Ok.
So how this asset type works? What makes it different from other
types of assets? And how PE creates this value today so much sought-after? What
is underlying its value chain? Is there a house secret inside PE that makes it
so appealing? Why PE firms and funds almost always outperform traditional
groups and corporate holdings also involved in acquisitions and disposals of
units, subsidiaries and other affiliates?
The purpose of this first part is to answer clearly and concisely
all these questions that might come to you when dealing with the PE industry.
Chapter 1 will explain what type of asset class is PE and how investors look at
it against other financial assets. Chapter 2 will give an insight on the value
chain sequence in PE and how value is created and cashed in through the entire
investment process. Chapter 3 will delve into more strategic insight by trying
to enlighten the reader on the strategic secrets of PE and what makes it
outperforming traditional business management in terms of returns and value
creation.
Chapter 1: What type of asset class is PE?
Definition:
What is Private Equity? «Any equity investment in a company
which is not quoted on a stock exchange». Although everyone agrees on this
basic definition, it is no more an exact one since an increasing convergence
between the activities of private equity funds, hedge funds and property funds.
Hence, let's get clearer about what is exactly Private Equity.
The most fundamental distinction in the PE industry is between
those who invest in funds and those who then manage the capital invested in
those funds b making investments in companies. This distinction is also defined
by the terms «Fund Investing» and «Direct Investing».
Terminology:
Those who invest in funds are called «LP's», since the
most common form of PE fund is a Limited Partnership; the passive investors are
called Limited Partners. Whereas direct investment where money gets channeled
into investee companies is the role of the PE manager called «GP» for
General Partner.
The investment process may therefore be seen as two levels: the
fund level and the company level, and this distinction is the difference
between «fund investment» and «direct investment». In fact,
each level requires its own particular modeling and analysis, and each also
requires its skills.
Structure:
But how these PE funds work? Usually, a limited partnership is
known as a close end fund since it has a finite lifetime typically between 10
and 12 years. This always has been the case in USA and UK but les the case in
other regions. In Europe for example, much private equity investing took place
through open-ended structures. These called «evergreen» vehicles were
the subject of lot of criticism from the Anglo-Saxon observers who claimed that
they provided little incentive to managers to force exits from their
investments and that their returns could not validly be compared with LP's
because typically there was no mechanism for them to return capital to
investors.
Cash Flow:
PE funds are unlike ay other form of investment in that they
represent a stream of unpredictable cashflows over the life of the fund, both
inward and outward. These CF are unpredictable not only as to their amount but
also as to their timing.
When a fund needs cash, either for the payment of fees or the
making of investments, the GP will issue a «drawdown notice»
sometimes called Capital Call. This will ask for a certain amount of money to
be paid into a specified bank account by a certain date and will give brief
details of what the money is required for.
The LP will then check that the purposes for which the money is
required are valid according to the terms of the LPA (Limited Partnership
Agreement) and that the amount has bee correctly calculated. It will then take
steps to execute the «drawdown notice» by making the required bank
transfer.
Distributions are the other side of the cash flow. Whenever a
fund exits an investment by sale or IPO, then they will have to cash available
to return to investors. This is usually done by a «distribution
notice» which is just the opposite of a «drawdown notice», and
will notify each individual investor of how much money they may expect to have
transferred into their bank account, and when. Since the timing of exits is
unpredictable the so necessarily is the timing of distributions. And to inject
further uncertainty into the situation, a fund may actually sell its stake in a
company in tranches over time.
Investment:
The most important thing to understand about the way in which a
PE fund invests is that investment power is in the manager or GP hands. The LP
have no voice at all in the investment process and, indeed, should not want to
have since there is a significant risk of them losing their limited liability
if they can be shown to have played an active part in the management of the
fund.
The combination of passive investing and long fund lifetimes has
made private equity a risky asset for some and has emphasized the need for
extreme care and specialist skills in the selection of managers in the first
place.
Fundraising:
Most PE funds tend to work to a 3-year fund cycle which means
that in the third year of Fund I they will be out fundraising for Fund II, and
so on.
The first step in the fundraising process should be for the PE
team to sit down and plan their investment model for their next fund. This
should consist of mapping out where the most lucrative returns are likely to be
made, assessing how many of these investments they can secure, and thus how
many are likely to be made in a 3-year period and how much money is required
for them. They will then choose to raise exactly that amount of money plus a
small contingency and no more.
The next stage in the process is to prepare an Offering
Memorandum (sometimes called a Private Placement Memorandum) which is the legal
document on the basis of which investment will take place, although the actual
contractual document is of course the LPA, which will be signed separately by
each investor, or made the subject of a subscription agreement, which will be
signed separately by each investor.
What happens next is usually that the decision process is
preceded or followed by a period of due diligences, during which the LP's team
will carry out as much analysis and checks on the GP's. In practice, it is
probably more accurate to say that in most cases the decision process will be
accompanied by the due diligence process, since some analysis may well be done
at a very early stage; on the historical financial performance for example;
while the final decision may well be expressly subject to due diligence which
has yet to be carried out.
The final stage in the process sees the lawyers intervening as
the terms of the LPA are debated and negotiated. In reality, such is the
bargaining strength of the GP's in desirable funds that little of any substance
is usually conceded to LP's.
Returns:
How Returns are measured in PE and why? How may we compare them
with the returns of other asset classes? These are several questions that this
section will try to address.
First, what lies at the heart of how Private Equity works is the
concept of the «J-curve». And this is exactly what makes PE so
different from the other asset classes. Indeed, «Annual Returns»
cannot be used as a guide to PE performance, whereas for most people this is
the only return that matters for every other asset class.
We already said that unlike any other asset classes, an
investment in a PE fund represents an investment in a stream of cash flows. Of
course there are other assets which would appear to satisfy this definition
like bonds, but a huge difference remains between the two assets. Because a
bond has typically one cash outflow and then a series of cash inflows with the
exact dates and amounts, we can calculate at any time the yield of as bond.
In a PE fund, we will rather have a series of cash outflows as
money is being drawn down from the LP's, but both the timing and the amount of
these outflows is totally uncertain. In the same way, there will be a series of
cash inflows as the GP distributes the proceeds of investments as they are
realized, but again its is completely impossible to predict in advance how much
each one of these will amount to, or when it will occur. In fact, the
calculation of a return in the case of a PE fund can only be made once the very
last cash flow has occurred. More than that, usually the biggest inflows tend
to occur at the end of the fund's life rather than in the beginning.
Hence, we need to look at the compound return over time which is
the IRR of a PE fund in order to assess its performance. And it is there when
we meet the famous «J-curve» phenomenon. In fact, the J-curve is
produced y looking at the cumulative return of a fund to each year of its life.
The first entry represents the IRR of the fund for the first year of its life;
the second entry represents the IRR for the first two years, and so on. In this
way, any PE fund will show strong negative returns in the early years as money
is drawn down. However, as distributions start to flow back to the investor
then the downward shape of the IRR curve will be reversed and there will come a
year when the amount of inflows will precisely match the amount of outflows,
creating an IRR of zero. This is the point when the J-curve crosses back over
the horizontal axis and subsequent IRR's start to become positive and upward
sloping. It is this difficulty of being able to abandon the annual returns view
and look from the perspective of compound returns that makes the PE industry so
different and perhaps so compelling amid the entire financial industry.
Thus, PE returns are calculated and stated not as the annual
returns of any year, but as compound returns from a certain year which is the
year of creation of the fund to a specified year. When looking at benchmark
figures in the industry as a whole or as any part of it, the all the funds
which form part of the sample that were formed in the same year are grouped
together and their returns become what we call the «Vintage year
return». In fact, the «vintage year» will always show the
compound return of all funds formed during the vintage year, from the vintage
year to the date specified. If we also look at the J-curve, we realize that at
any time, the vintage year returns for the last few years meaning the most
recent should be very low or even negative because they represent the
equivalent of the first few years of the J-curve, at a time when even the best
PE funds will show negative returns. And subsequently, the greater the number
of years over which a vintage year compound return is calculated, the more
robust it becomes, the less deviation there is likely to be between it and the
final fund return. It is indeed meaningless to look at the performance of a PE
fund in the early years; generally these are the first five years.
Now that we clearly defined the asset class and explained how it
works and how its returns are viewed and computed, let's turn to the next
chapter and see how the PE asset class creates value for its investors and what
is the exact process of value creation for a PE fund. In other terms, let's
try to mirror and understand from a sequenced process perspective, the J-curve
and the compound returns of a PE fund we just touched on in this chapter.
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