Primer

on Private Equity
Edited Summary of The Oxford Handbook of Private Equity

Introduction to Private Equity

This primer introduces the reader to the financing and governing behaviours employed
by private equity investors in order to manage investment risks and related agency
problems. A special focus is devoted to how venture capitalists affect the governance
of their portfolio companies. Private equity and leveraged buyout transactions
represent crucial governance mechanisms to restructure firms.
Venture capitalists contribute to improving the
governance structure of the firms they finance by
influencing their board composition, creating a more
independent and involved board, and providing
strong oversight.

Defining: Private Equity

The term private equity refers to the expansion financing
of existing firms. The definition includes leveraged buyout
(LBO) transactions and excludes start-up financing (defined
as venture capital [VC]). A leveraged buyout involves the
acquisition of the equity capital of a target firm with the
adoption of a large amount of debt relative to the asset
value of the target.

A growing body of economic literature shows that

private equity investors provide valuable managerial
support to their investment companies by playing an active role in monitoring and
governing them, as well as offering them crucial value-added advice and services.

The ultimate investment depends not only on the quality of the entrepreneurial team,
but also on the effort exercised by both the entrepreneur and the venture capitalist,
who is supposed to provide valuable managerial
support and services to portfolio firms. To mitigate Defining: Private Equity Investors & Venture Capitalists
these problems, venture capitalists need to devote a Private equity investors target high-growth-potential firms
with the hope of receiving an adequate return to
great amount of time and effort in setting compensate their underlying investment risk.
appropriate
mechanisms
to
incentivize
the Venture capitalists derive their returns from the capital gain
entrepreneur to act in the best interests of the they obtain by divesting (or exiting) their portfolio
companies.
company and the venture capitalists.
Venture capitalists devote significant attention and time to screening and evaluating
the investment proposal in order to select the most attractive ones. According to
economic literature and empirical evidence, the positive influence that venture
capitalists exercise on the governance of their portfolio firms seems to lead to better
firm performance.
Information Asymmetry and Agency Problems
In the absence of appropriate screening and control mechanisms, the presence of
information asymmetry and agency problems may lead to:
Adverse selection, which arises before the financing is made and refers to a
situation of misrepresentation of reality by the entrepreneur in order to induce
the venture capitalist to provide the financing.

Primer on Private Equity

Edited Summary of The Oxford Handbook of Private Equity

Moral hazard, which arises after the financing is made and refers to the
possibility that the entrepreneur will employ opportunistic behaviours against the
venture capitalists. The moral hazard problem is driven by a divergence of
interests between the principal and the agent. The difficulty of combining the
interests of the venture capitalist and those of the entrepreneur, as well as the
difficulty of controlling and verifying the actions of the entrepreneur may
encourage detrimental opportunistic behaviour.
The interaction between the venture capitals and the entrepreneur is affected by
agency problems and conflicts of interests, mainly due to asymmetric information that
may lead to adverse selection and moral hazard consequences. To mitigate these risks,
venture capitalists have learned to employ different risk mitigation mechanisms, such as
adopting specific forms of finance and governance strategies.
Defining: Information Asymmetry

The Economics of Seinfeld - Asymmetric Information

Information Asymmetry is when somebody knows more than

The Fusilli Jerry

Jerry's car is broken and he takes it to a new mechanic. The new
mechanic gives an estimate that Jerry believes is too high.
George says, Of course they're trying to screw youthat's what
they do. It's because you don't know anything about what's going
on under there! George also says that Putty, Jerry's regular
mechanic, wouldn't try to screw him. Reputation for honesty can
overcome moral hazard problems.

somebody else. Such asymmetric information can make it difficult

for the two people to do business together, which is why
economists, especially those practising game theory, are
interested in it. Transactions involving asymmetric (or private)
information are everywhere. A government selling broadcasting
licences does not know what buyers are prepared to pay for them;
a lender does not know how likely a borrower is to repay; a usedcar seller knows more about the quality of the car being sold than
do potential buyers. This kind of asymmetry can distort people's
incentives and result in significant inefficiencies.
Source: The Economist - Economic Terms A to Z

The Fusilli Jerry - Asymmetric Information - Video Link

Defining: Agency Problems

An agency problem is a conflict of interest inherent in any
relationship where one party is expected to act in another's best
interests. The problem is that the agent who is supposed to make
the decisions that would best serve the principal is naturally
motivated by self-interest, and the agent's own best interests may
differ from the principal's best interests. The agency problem is
also known as the "principalagent problem."

In corporate finance, the agency problem usually refers to a

conflict of interest between a company's management and the
company's stockholders. The manager, acting as the agent for the
shareholders, or principals, is supposed to make decisions that
will maximize shareholder wealth. However, it is in the manager's
own best interest to maximize his own wealth. While it is not
possible to eliminate the agency problem completely, the
manager can be motivated to act in the shareholders' best
interests through incentives such as performance-based
compensation, direct influence by shareholders, the threat of
firing and the threat of takeovers.

Source: The Economist - Economic Terms A to Z

Primer on Private Equity

Edited Summary of The Oxford Handbook of Private Equity

Private Equity Risk Mitigation

Financial contracting, control rights, and governance mechanisms play a crucial role in
mitigation agency problems between venture capitalists and entrepreneurs, as well as
providing the entrepreneur with the incentives to act in the best interest of the venture
capitalist and the company.
The choice of security in venture capital financing is context-contingent because it
depends on the type of invested firm and on the type of transaction, as a response to
different agency problems underlying the specific transaction.
The legal environment and securities regulation also represent important determinants
for venture capital contracting behaviour.
More experienced venture capitalists tend to adopt a more sophisticated approach
toward risk management. Sophisticated venture capitalists use the U.S.-style contract
approach (characterized by the dominance of convertible securities), regardless of the
legal origins.
Sophistication is proxied by size of the venture capital (in terms of capital under
management), age of venture capital firms (at least four years), and previous U.S.
experience. Venture capitalists are more likely to use the U.S.-style contract when they
are older, larger, and have U.S. experience.
In civil law countries with low enforcement, venture capitalists tend to use common
stocks and debt (instead of convertible securities) and tend to rely more on board
control. Preferred stocks are used mainly in common law counties with high
enforcement.
The choice of securities is context-dependent: it mainly depends on the characteristics
of the invested firms, as well as the institutional and legal environment.
Screening and due diligence are important mechanisms to minimize adverse selection
risk. The different groups of risk screening criteria used by venture capitalists may fit
into the following categories:
Firm: Criteria related to the target firms characteristics (e.g. business history,
firm age, development stage).
People: Criteria related to the quality, experience, and track record of the
management team.
Opportunity: Criteria related to the uniqueness and technology of the project or
product, the business plan, and cash flow potential.
Context: Criteria related to the market context (industry, competitors, suppliers,
entry barriers).

Primer on Private Equity

Edited Summary of The Oxford Handbook of Private Equity

Investment Risks and Reward: Criteria related to the investments characteristics

and the related risks and returns (e.g. invested amount, venture capital
ownership stake, time to reach the break-even point, strategic fit with other
portfolio firms, expected internal rate of return (IRR), risk analysis).
Risk Mitigation - Convertible Securities
Convertible securities, especially if accompanied by the automatic conversion provision,
appear to be the optimal contractual scheme to overcome agency conflicts between
venture capitalists and entrepreneurs and to better manage adverse selection and
moral hazard risks.
Convertible securities seem to be particularly Statistics on Convertible Securities vs. Common Stocks
attractive for various reasons. First, they combine U.S.-style contracts (convertible securities) are less likely to
elements of debt and equity and help to mitigate fail, whereas 41 percent of venture capitalists that used
adverse selection and moral hazard problems, such common stocks have failed.
as window-dressing problems. Second, convertible Inexperienced venture capitalists may not completely
understand the benefits offered by preferred stocks and
securities, especially in the form of participating may choose common stocks.
convertible preferred equity, ensure the venture
capitalist greater control rights and greater downside
Tendencies of Common Equity
risk-protection (because venture capitalists have a
Common equity is more likely to be chosen by low-return
claim on the assets of the firm as long as they choose entrepreneurs (the lemon principle), while high-risk
to not convert their securities). Third, convertible entrepreneurs (nuts) are more likely to be attracted by
preferred stocks allow venture capitalists to transfer debt contracts.
the risk to the entrepreneur in the worst-case scenario. Fourth, they provide the
holders with the right to convert them into equity. Prior to conversion, the venture
capitalists holds a debt-like security with an option of conversion into equity, and until
conversion these types of securities provide the venture capitalists with preferred
dividends and liquidation priority rights. If conversion occurs, the venture capitalist
loses dividend preferences and gains the ordinary dividends associated with common
stocks.
The key features of these types of securities are (a) Defining: IPO
they allocate different cash-flow rights depending on An IPO or Initial Public Offering is the process by which a
the type of exit (IPO or acquisition) that will occur; (b) company transforms from being a private company to a public
company through the sale of shares to the public.
they provide the venture capital with control power
because the voting rights are applied on an as-if-converted basis. Given that these
securities are often accompanied by an automatic conversion provision at the time of
IPO, if the exit occurs through an acquisition the venture capitalist still holds preferred
security. On the other hand, if the exit occurs via IPO venture capitalists automatically
convert their securities into equity and will end up holding common stocks. Therefore
4

Primer on Private Equity

Edited Summary of The Oxford Handbook of Private Equity

cash-flow rights are higher in the case of exit than through an acquisition than through
an IPO. Moreover, given the voting rights on an as-if-converted basis, the conversion
will not change the control rights held by venture capitalists.
Risk Mitigation Differences Between the United States and Canada
Convertible preferred stocks represent the most used form of
finance in the United states. Outside the U.S. market, in fact,
convertible securities are not the most commonly use form of
finance. Instead a larger set of financial securities are adopted by
venture capitalists.
When there are no tax benefits from the use of convertible
securities (as seen in Canada), U.S. venture capitalists tend to use
a heterogeneous mix of forms of finance.
Contrary to empirical evidence in the United States, in Canada a
wide variety of forms of finance are used. Among them, common
equity seems the most frequently used security: almost half of
Canadian private equity financial contracts include common
stocks.
Form of Financing

The use of convertible securities in the United States is justified by

favourable tax treatment. However, the banking system in Canada
is highly concentrated, and there may be fewer debt finance
opportunities available for entrepreneurs. This open space may
incentivize U.S. venture capitalists who want to invest in Canada
to follow a one-stop shopping financing approach, by offering
Canadian firms a wide set of alternative financing possibilities.
In Canada, convertible securities are not the most frequently
used. U.S. venture capitalists investing in Canadian firms use a
variety of forms of finance other than convertible securities. The
following table details the other forms of finance used for
Canadian private equity financial contracts.
Percentage of Total Forms of Private Equity Financing in Canada

Common Equity

37% of Cases

Debt

15% of Cases

Convertible Debt

12% of Cases

Mixes of Debt and Common Equity

11% of Cases

Straight Preferred Equity

11 % of Cases

Different Other Combinations of Preferred Equity and Debts

8% of Cases

Straight Preferred Equity

7% of Cases

Risk Mitigation - Control and Cash-flow Rights

Behaviour of Private Equity Investors

Private equity investors behave differently depending on
the type of transaction (buyout or expansion).
In expansion deals venture capitalists often acquire a
minority equity stake. In contrast, a controlling majority

Primer on Private Equity

Edited Summary of The Oxford Handbook of Private Equity

Private equity investors separately allocate control equity stake is typically acquired in the case of buyouts.
and cash-flow rights between venture capitalists and
entrepreneurs in order to mitigate agency problems.
Control rights are often made contingent on
performance measures. Thanks to these contingencies, the venture capitalist gains
more control rights or full control if the firm performs badly or if the targeted objectives
are not fulfilled. If the firm performs well, the venture capitalist decreases control rights
and gets more cash-flow rights instead.
Venture capitalists may adopt different types of control rights: control over production
and marketing decisions, power of hiring and firing of the CEO, power of having board
control, and veto rights over some particular decisions (such as the issuance of
securities, merger and acquisition possibilities, or large capital expenditure decisions).
The presence of strong venture capitalist control rights (such as board control, veto
rights, and the right to replace the CEO) is associated with a greater probability of
exiting through an acquisition rather than through an IPO or write-off.
Examples of different control and protective rights retained by venture capitalists
include:
Cash-flow rights: Claims on cash payouts.
Dividend priorities and liquidation rights: When venture capitalists hold
preferred stocks, they expect to have priority rights over common shareholders
in the event of dividend payments, liquidations, or merger.
Voting rights
Control rights: Venture capitalists typically hold a vast set of control rights (e.g.
power of hiring or firing the CEO, right to replace the founder or the
entrepreneur, right to retain board control, right to set restrictive covenants or
stock transfer restrictions).
Board representation rights: The venture capitalists retains the right to choose
one or more board components, as well as the right to increase board
representation in the case of poor firm performance or inexperience
management team.
Veto rights: The veto rights included in private equity contracts may be related
to asset sales, asset purchases, ownership changes, and equity increases.
Information rights: Investors often retain the right to receive information on
financial statements and other firm-related information.
Right of first refusal in sale: This represents a call option for the venture
capitalist. When a shareholder wants to sell his or her shares, the private equity
investor has the right to buy them before the shares are offered to a third party.

Primer on Private Equity

Edited Summary of The Oxford Handbook of Private Equity

Pre-emptive rights on new share issues: In the case of issuance of new shares,
venture capitalists have the option of maintaining their ownership stake into
targets equity by acquiring at least the same percentage of the future share
offering.
Exit rights: International literature shows that venture capitalists structure their
deals in order to facilitate their future exit; they may preplan possible exit routes
or retain several exit rights to ensure an exit. Venture capitalists in fact acquire
an equity stake in a target company with the aim of exiting their investment after
a few years. The divestment allows them to have sufficient liquidity to guarantee
a satisfactory rate of return to their external investors.

Contingencies
Contingencies are events upon which a change in the control
rights and ownership structure of the business would occur. The
most used contingencies included in venture capitalist term
sheets are related to the achievement of:

Economic milestones (sales, EBITDA, EBIT)

Financial milestones (ROE, EPS, cash flows, debt-equity
ratio)
Strategic objectives (such as patents, client number,
strategic market positioning)

Changes in control rights may also occur in the case of breaches of

contractual investor provisions, as well as in the case of asset sale.
Private equity deals are structured so as to attribute more control
power to the entrepreneur if the company performs well.
Therefore, if the company reaches the pre-planned milestones,
the controlling power exercised by venture capitalists decreases
over time; if the company fails to fulfill certain milestones or
objectives, the venture capitalists acquire full control.

Risk Mitigation - Board Control

Governance and contractual investor rights represent important mechanisms adopted
by venture capitalists to mitigate risk and agency conflicts. For example, private equity
investments are structured in such a way as to allow venture capitalists to actively
participate in the managing activity of their portfolio companies through different
control rights (contractually regulated), veto rights, board representation, protective
provisions, affirmative and negative covenants, exit rights and stock transfer restrictions.
Typically venture capitalists expect to partake in management decisions by having a
strong position on the board of their portfolio companies. Venture capitalists often
negotiate with the entrepreneur the right to take full control of the board of directors if
the company fails to reach certain milestones or certain business plan goals, as well as if
the entrepreneur and management team violate certain contractual provisions.
Furthermore venture capitalists expect to increase their representation rights in the

Primer on Private Equity

Edited Summary of The Oxford Handbook of Private Equity

case of poor firm performance or in the case of a weak or inexperienced management

team.
Risk Mitigation - Syndication
Another risk mitigation mechanism is represented by syndication. The decision to
invest is often conditional to the presence of syndicated investors. Syndication
mitigates adverse selection problems and helps venture capitalists select high-quality
projects. Venture capitalists seek syndication not only to minimize adverse selection
risks, but also to share the overall investment risk and to increase portfolio
diversification. Additionally the specialization and previous industrial experience of
venture capitalists play a crucial role in the success of the investment.
Generalist investors are associated with poorer firm performance that are due to
inefficient allocation of funds across industries and to inefficient selection of investment
projects.
Risk Mitigation - Stage Financing
An incentive mechanism often adopted by venture capitalists is represented by stage
financing, which allows venture capitalists to monitor the progress of the project and
the firm. By staging the capital injections in such a way that each financing tranche is
contingent on reaching a particular goal, the venture capitalist retains an option to
abandon the project.
The possibility of abandoning the venture may be a threat for the entrepreneur, who is
then encouraged to maximize effort and work in the best interests of the company.
Stage financing may also have some side effects and sometimes fails as an incentive
mechanism. For example, it may induce the entrepreneur to engage in opportunistic
behaviour (such as window dressing or reality misrepresentation) in order to receive the
next round of financing.
Risk Mitigation - Debt
Debt is frequently considered a powerful incentive mechanism for managers to reduce
agency costs and align management interests with those of shareholders (the
disciplining role of debt). Debt increases the probability of attracting high-risk firms
(nuts) who follow the Heads I win-tails you lose investment logic.