Private Equity
Private Equity
Private Equity
PRIVATE EQUITY
AND VENTURE
CAPITAL
By Professor Stefano Caselli
Universit Bocconi and SDA Bocconi
Content
1. What Is Private Equity and Venture Capital?
2.
3.
4.
5.
Expansion Financing
6.
Replacement Financing
7.
Vulture Financing
8.
Preliminary Definitions
The definition of Private Equity (PE) is based on two aspects, each related to the
two man characteristics of the PE relation:
PE is a source of financing: It is an alternative to other sources of
liquidity, (such as a loan or an initial public offering (IPO)) for the
company receiving the financing.
PE is an investment made by a financial institution: Private Equity
Investor (PEI) in the equity of a non-listed company (i.e. not a public
company).
Throughout the course, the definition of PE will be used in its broad meaning, which
also includes Venture Capital.
Venture Capital is a very specific case of PE. It is the investment in the very early
stages of a companys life.
3
Debt
Assets
es
shar
Equity
Private
Equity
Investor
cash
PRICING
LIQUIDITY
MONITORING
Public
Private
Content
1.
4.
5.
Expansion Financing
6.
Replacement Financing
7.
Vulture Financing
8.
Private Equity and Venture Capital: Today and Tomorrow Interview with
Fabio Sattin
1. Certification Benefit
2. Network Benefit
3. Knowledge Benefit
4. Financial Benefit
8
10
11
EQUITY
RATING
Other
Partners
Angels
Private
Equity
Banking
System
Trade
Credit
Financial
Markets
Development
Startup
Early Growth
Mature Age
To do
something
complex
Expansion
Crisis or
decline
It goes back
to them
Maybe for an
IPO
They
disappear
13
Content
1.
2.
5.
Expansion Financing
6.
Replacement Financing
7.
Vulture Financing
8.
Private Equity and Venture Capital: Today and Tomorrow Interview with
Fabio Sattin
15
Startup
Development
Startup
Financing
Seed Financing
Time = 0:
Birth of the
company
Replacement
Financing
Expansion
Financing
Early Growth
Financing
Crisis or
decline
Vulture
Financing
Time
16
18
19
Content
1.
2.
3.
Expansion Financing
6.
Replacement Financing
7.
Vulture Financing
8.
Venture Capital
Mature Age
Expansion
Early Growth
Startup
Development
Startup
Financing
Seed Financing
Time = 0:
Birth of the
company
Replacement
Financing
Expansion
Financing
Early Growth
Financing
Crisis or
decline
Vulture
Financing
Time
21
Seed Financing
The Seed Financing is the most complex and riskiest activity among the PE
investment.
It is the investment of an idea or of an research and development (R&D) project, it is
in fact very industry-oriented: it usually deals with the biomedical, IT, and the
pharmaceutical industries / sectors. Under seed financing, the uncertainty of the
project is high because the investor has to trust the idea of the entrepreneur. This is
why the managerial role of the investor is very limited.
There are two levels of risk:
1. The capability for the idea to generate on output
2. If there is an output: does this output have a marketability?
22
Seed Financing
Because this phase is very risky, there are three golden rules an investor needs to
know:
1. 100/10/1 RULE
The investor has to screen one hundred projects, finance ten of them and be lucky (and
able) enough to find the one successful one.
The activity is risky that you must invest on much more that one project. The investor
needs to invest a huge amount of money. The psychological threshold is one billion .
By the time the investors find the winning project they will have lost much of their
beginning investment.
Because this investment occurs before the company is founded, the investors have to
protect themselves in case the person owning the projects idea suddenly can no longer
preform his or her job.
The solution to this risk is in the Incubator Strategy, an ad hoc infrastructure in which
the inventor can work without worrying about his or her ideas being stolen.
23
Seed Financing
3. SIZE OF THE MARKET
The investors usually invest in the markets they know the best.
Despite this, in some cases, the idea may be a good one without a market willing to buy
it.
Such is the case in which the investors look for venture philanthropy, set up by nonprofit institutions with the investors themselves.
24
Startup Financing
The Startup Financing is the financing of a new company starting its own initial
operations.
The entrepreneurs and the founders need of cash derives from the necessity to buy
the necessary equipment to start (e.g. equipment, inventory, building, etc.) the
business. In this kind of financing the risk is still very high, leading to a high level of
protection for the investor.
The level of risk depends on the fact that the PEI is betting on a business plan.
Because the investor is neither a non-profit organization nor a High Net Worth
Individual (HNWI), there are several ways in which this can occur.
1. PUT OPTION
This tool is used to sell back to the entrepreneur the shares the investor bought. This
tool is quite dangerous: it assumes that if the business plan does not work, the founder
will still have money to pay off the PE. For this reason, the put option may be used
together with a second tool
25
Startup Financing
2. COLLATERAL
This is a pledge for the investor over some valuable assets of the newly founded
company and this is usually used together with the put option.
Another way to reduce the risk the business plan is not accurate and reliable is to grant
the inventor some stock options. In this way the entrepreneur will also enjoy the
profitability of the company.
The PEI needs to find the right combination between not losing all its investment (such
is the case when the PE owns 95% of the equity) and not having any say in the
management of the business (such is the case when the PEI owns 2% of the equity)
For instance, for the investor the right balance would be owning 48% of the company.
In such case the PEI would have the right to
lead the company but the founder is the
owner of the company.
26
28
Content
1.
2.
3.
4.
5. Expansion Financing
6.
Replacement Financing
7.
Vulture Financing
8.
The PE Clusters
In clip 4 the venture capital has been presented. In the following Clips (5, 6, and 7), we will see
the other clusters belonging to the PE family which are made for the phases of expansion,
mature age, and crisis.
Venture Capital
Mature Age
Expansion
Early Growth
Startup
Development
Startup
Financing
Seed Financing
Time = 0:
Birth of the
company
Replacement
Financing
Expansion
Financing
Early Growth
Financing
Crisis or
decline
Vulture
Financing
Time
30
Expansion Financing
The expansion financing takes place in the fastest phase of growth of a firm to consolidate
its position in the market.
The investment is only used to sustain the (reducing) gap existing between the cash flow
and money needed.
In this phase, the level of risk is moderate (and it mostly depends on the business) because
the trend of development of the business is well known.
In this cluster the stake held by the PE is not usually very high.
The expansion financing deals are about the growth of a company.
Expansion Financing
Internal Growth
We say that a company grows via internal growth when it plans to grow by itself.
This means that investments in fixed assets and in working capital will be made.
The role of the PEI: the investor needs to provide money to the venture backed company in order
to buy and/or sustain the procurement of working capital and to purchase new assets.
Because this kind of deal is not difficult for a PEI, the offer is very wide and there is a very
high number of investors providing this financing.
This kind of financing can be an alternative to a loan.
Why should a company choose PE over a bank?
Because the need for extra money comes with other
needs which can be accomplished with one of the
four benefits seen in Clip 2.
There may be the need for the PE network or the
need to build a good reputation.
32
Expansion Financing
External Growth
We say that a company grows via external growth when it plans to grow by acquiring another
company (i.e. carry on an M&A) in order to enhance the level of sales and exploit the synergies
coming from this operation. This path is much more complicated than the internal growth and it
may be undertaken by an adult company in order to enter a new market.
The role of the PEI: the investor has to sustain the M&A and in this case, they not only have to
provide the venture-backed company with the money necessary, but they also have to:
a.
b.
c.
d.
e.
f.
Hands on approach
33
Expansion Financing
External Growth
The injection of money can be done in two ways:
1. The PEI invests in the venture-backed company, from which it gets shares and the
company has to get enough money to carry on the M&A. If the process is successful
the venture-backed company and the target will merge.
Venture-Backed
Company
Debt
TARGET COMPANY
Assets
Equity
Equity
PEI
34
Expansion Financing
External Growth
The PROs
The venture-backed company will merge with the target and the company will
benefit from the synergies.
The CONs
The venture-backed company is going to give the investor a portion of the synergies
created.
In order to address this drawback, there is another way to do and M&A using PE.
35
Expansion Financing
External Growth
2. The second way in which this M&A can be done is as follows:
The PEI builds a Special Purpose Vehicle (SPV). The SPV is an empty box built
only for the purpose of a specific extraordinary operation. This company does not
have any assets nor liabilities and equity before the operation takes place.
The PEI and the venture-backed company collect money from the banking system
and put the cash collected in the SPV.
In this way, they will have enough capital to buy another company.
This option can be used in two cases:
a. When the venture-backed company has got a huge financial need and it does not want
to further increase the amount of debt.
b. The company wants to keep the SPV as a separate entity, this happens when the
company does not want the PEI to share the gain deriving from the M&A process.
36
Expansion Financing
External Growth
Venture-Backed
Company
SPV
cash
cash
Debt
Equity
Assets
PEI
Equity
cash
cash
BANKING SYSTEM
37
Expansion Financing
External Growth
In this way, the PE will not benefit from the synergies created.
On the other hand:
This second option is more expensive than the first one;
The PEI has a minor incentive in creating synergies (this may entail that lower
synergies will be created)
The company has to obtain financing from banks to invest in the SPV:
38
Content
1.
2.
3.
4.
5.
Expansion Financing
6. Replacement Financing
7.
Vulture Financing
8.
PE Clusters
Replacement Financing occurs when a company is beyond the phase of fast growth
and is in the mature age stage.
Venture Capital
Mature Age
Expansion
Early Growth
Startup
Development
Startup
Financing
Seed Financing
Time = 0:
Birth of the
company
Replacement
Financing
Expansion
Financing
Early Growth
Financing
Crisis or
decline
Vulture
Financing
Time
40
Replacement Financing
Replacement financing takes place in the mature age of a company and the
role of the PEI is that of replacing an existing shareholder.
A company needs replacement financing when it wants to face strategic decisions
linked either to governance, status, or corporate finance decisions.
The level of risk is moderate and linked to the quality of the strategic process that
has to be put in place.
There are three kinds of operations belonging to this cluster:
1. Leverage Buyout (LBO)
2. Private Investment in Public Equity (PIPE)
3. Corporate Governance (CG) Deals
These deals do not derive
from the arise of need of
money of a company.
41
Leverage Buyout
LBO is very commonly used, especially in the Anglo-Saxon world, where they
account for 45%.
The role of an investor is not only to finance the company but to identify the target
company that the venture-backed company has to buy at 100%.
This operation takes place in the following steps:
1. When the PEI identifies the potential target, the PEI itself creates an SPV (for the
SPV definition, see clip 5) of which it becomes the full owner (i.e. 100%
shareholder).
2. The PEI collects money up and highly leverages the SPV up to a ratio of 90% debt
and 10% equity.
3. The SPV receives a huge amount of cash through which it is able to purchase the
target company.
42
Leverage Buyout
4. The SPV buys the target company either through a negotiation process or
through a hostile process and trough an IPO on the stock exchange. The
aggressiveness of the operation depends on the level of debt used by the
PE to buy the target company.
5. The PE fully owns the target company.
After the acquisition, the PE will sell the target to anther company.
43
Leverage Buyout
The target company usually has:
Relevant Cash Flow
Low D/E ratio
Assets that can be easily be sold on the market
SPV
BANKS
TARGET COMPANY
Debt
Cash
Debt
Assets
Equity
100%
Equity
PEI
44
45
46
Content
1.
2.
3.
4.
5.
Expansion Financing
6.
Replacement Financing
7. Vulture Financing
8.
PE Clusters
This is the final clip related to PE clusters.
The final stage of the life cycle of the company will be presented: Vulture (or
distressed) financing.
Venture Capital
Mature Age
Expansion
Early Growth
Startup
Development
Startup
Financing
Seed Financing
Time = 0:
Birth of the
company
Replacement
Financing
Expansion
Financing
Early Growth
Financing
Crisis or
decline
Vulture
Financing
Time
48
Vulture Financing
Vulture financing takes place in the final stage of a companys life cycle,
when it enters its decline phase or, worse, a crisis.
Money is used to sustain the financial gap generated from the decline of growth. The
financial aid coming from the PEI is used to launch a survival plan.
Due to the life stage, this activity is very risky, even though the level of risk also
depends on the sector of the venture-backed company. For this reason, the PEI fully
understand the field in which the company operates.
49
Vulture Financing
There are two deals included in this definition:
1. Restructuring financing (or turnaround)
2. Distressed financing
The separation of the vulture financing in two different kinds of deals derive from
two different ways to differently regulate the deals.
50
Restructuring financing
Distressed financing
Restructuring Financing
In restructuring financing, the company is facing a crisis, but is still alive.
The need of financing derives from the settlements of debts with banks and with
suppliers. At the same time, money can be used to re-launch the business, therefore
in some cases money can be used to buy further assets or invested to redesign the
business plan.
The company needs the strategic support from the PEI
These strategic needs make the PEI not only a financer for the troubled company but
also an advisor.
51
Restructuring financing
Distressed financing
Restructuring Financing
Because the risk is very high due to the strategic nature of the role of PE, the
investor is a majority shareholder: there is a very strong hands-on approach and
this needs a majority stake in the equity of the company.
For the high difficulty of the deal and due to the elevated riskiness of these
projects, it is very difficult to find a PEI investing in such deal, it is more of an
investment banking activity.
52
Restructuring financing
Distressed financing
Distressed Financing
Contrarily to replacement financing, distressed financing is a very common deal
for PEI and it occurs when the company is dead.
This may look a bit contradictory to the other clusters of PE in which the main goal
of a PE deal is to finance a company finding itself in the need of money.
The aim of PE is not in fact to merely finance the company, rather to buy the
relevant (and valuable) assets of the company.
In this case, an investor is going to buy:
Patents
Brands
Contracts
Equipment
53
Restructuring financing
Distressed financing
Distressed Financing
Why would a PEI want to buy the assets of a defaulted company?
1. In some cases, the PE may be a trader of assets. This means that the investment is
made only to sell such assets to a third buyer.
2. In other cases, the PEI buys the assets because it inserts them in other venture-backed
companies in its portfolio.
The assets are bought before a court, and the negotiation process can be tough between
the court and the investor. As a matter of fact, it is a desire of the court to maximize the
liquidity of a company when it goes bankrupt, so that it can pay off its debts.
Sometimes the court implements the poison pill. This means that the PEI is going to buy
a valuable asset mandatorily together with another less valuable assets or together with a
debt of the company.
These deals work differently according to the different countries. In the US, these deals
work very well: there is a chapter in the United States Bankruptcy Code dedicated to the
distressed financing (Chapter 11) (find out more about Chapter 11 at this link).
54
Content
1.
2.
3.
4.
5.
Expansion Financing
6.
Replacement Financing
7.
Vulture Financing
Q&A
Today, what is state of the art in private equity and venture capital all around the
world?
Today PE is an engine for the economic growth, especially for Europe and Italy.
As for Europe, one of the main hurdles is made up of the big role the banking system plays
(huge difference with respect to the US).
In Europe, There is the need to create a new financial intermediary, not bankingrelated, which should possess specific knowledge on companies and their development
and this is why PE can be (and is) so important in Europe.
Nowadays we can see an increasing interest in private debt, again standing as a signal that
PE in Europe plays a fundamental role.
Q&A
According to you, are Europe and the US are two different worlds concerning private
equity?
There is a European way to play PE which is very different from the American one.
I recall that years ago the, then Italian Ambassador, a big PE player in the US, once said
that Europe is a completely different market.
Why is that? Europe (excluding the UK) can be taken as one very big country with many
family businesses and PE can help them to develop this changes the approach a PE has
when investing in a family business.
We can say that PE has adapted also to invest in each specific country. Basing on my
experience in the US, I can tell that in continental Europe, PE players support
generational change: again, a different way to do PE.
Q&A
What are the key trends in the market for private equity and venture capital?
After the financial crisis, today PE is definitely changing like many other industries.
In the first place there is a problem at the fundraising level, which has become more
difficult and PE firms had to come up with new strategies to do fundraising, like club
deals, co-investments, SPACs.
The second problem is the fees structure. The fact that the fees are calculated on the
committed capital is under a review process by many funds.
Again, I see many sovereign funds investing in PE.
On the deal-side, in Europe SMEs are the main target for PE investments ( 45 bio
invested each year).
In the future, I think that the investments may have a different structure.
Q&A
The industry is changing: new strategies are coming up, in the US we see majority
investments, whereas we see minority investments in Europe. How do you see the
market in terms of strategic choices of the biggest players in the market, as the
company of yours?
One of the most important aspects is the fact that in Europe most deals are not very
large. In addition, minority investments will still make the majority of the deals.
For these reasons, PE firms are boosting their industrial skills in order to enhance their
industrial know how PE is not a replacement for the managers, they are active owners,
not active managers.
Having said that, it is necessary for the PE investors to have a solid knowledge of the
company and of the sector in order to help companies to develop their strategies.
This must be done without overlapping the role of the management team.