Assignment 2 Private Equity

Presented by: Bayer, Stefanie Cavaleri, Tobias Daz Palancar, Alfredo Stoll, Jrgen Stolz, Oliver

Lecturer: Dirk Zimmermann Class: Financial Management MBA GM06 (Spring 2010)

Due Date: 21.06.2010

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Table of Contents
Index of Figures ............................................................................................................... iii Index of Tables ................................................................................................................. iii Index of Abbreviations ..................................................................................................... iv 1 Introduction and key definitions ................................................................................ 1 1.1 1.2 1.3 2 3 What is Private Equity? ...................................................................................... 1 Private Equity Firms ........................................................................................... 2 Private Equity Funds .......................................................................................... 3

Market size and major trends 2010 ............................................................................ 5 Types of Private Equity transactions ......................................................................... 9 3.1 3.2 3.3 3.4 Venture Capital ................................................................................................. 10 Growth (Expansion) Capital ............................................................................. 12 Acquisition / Buyout financing transactions .................................................... 12 Other types of transactions ............................................................................... 14 Secondary buyouts .................................................................................... 15 Mezzanine Financing ................................................................................ 15

3.4.1 3.4.2 4 5

A typical MBO process............................................................................................ 16 Private equity as a financing source ........................................................................ 19 5.1 5.2 5.3 5.4 Key findings on Productivity and Management performance .......................... 20 Key findings on Strategic Portfolio and continuity .......................................... 21 Key findings on employment ........................................................................... 21 Summary of Pros and Cons on the PE as financing activity: ........................... 23

Bibliography.................................................................................................................... 24 Appendix ......................................................................................................................... 27

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Index of Figures
Figure 1: Private vs. Public Equity (own illustration based on (Bundesverband Deutscher Kapitalbeteiligungsgesellschafen)) .................................................................. 2 Figure 2: Private Equity Fund Diagram (How do Private Equity Fund Investments Work? 2010)...................................................................................................................... 4 Figure 3: Global LBO volume in US$billion by Region, January thru June 2009 (RREEF Research 2009) ................................................................................................... 5 Figure 4: Growth of primary and secondary PE market (RREEF Research 2009) .......... 7 Figure 5: Product Life Cycle (Fraser-Sampson 2010, 8) .................................................. 9 Figure 6: The MBO-Participants and their roles (own illustration based on (Manches LLP)) ............................................................................................................................... 17 Figure 7: Organizational and financial flow of a MBA-process (own illustration based on (Manches LLP) and (Hoffmann et al. 1992, 68))....................................................... 18 Figure 8: Private equity-owned firms have the best raw management practice scores on average (The Global Economic Impact of Private Equity Report 2009, 11) .................. 20 Figure 9: Manufacturing employment under private equity targets: year and as percentage of manufacturing sector employment (The Global Economic Impact of Private Equity Report 2009, 39)...................................................................................... 22 Figure 10: Private Equity Landscape Chart (Tuck Center for Private Equity and Entrepreneurship) ............................................................................................................ 28

Index of Tables
Table 1: Real GDP chance (RREEF Research 2009) ....................................................... 5 Table 2: Future trends within private equity (own illustration) ........................................ 8 Table 3: Comparison of the three main types of Private Equity transactions (own illustration) ...................................................................................................................... 10 Table 4: Pros and cons of PE as an alternative financing source (own illustration) ....... 23

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Index of Abbreviations
APAC Asia-Pacfic BRIC Brasil, Russia, India, China GP General Partner LBO Leveraged Buyout LP Limited Partner MBI Management Buyin MBO Management Buyout PE Private Equity SBIC Small Business Investment Companies VC Venture Capital WEF World Economic Forum

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Introduction and key definitions

1.1 What is Private Equity?

Private equity is money invested in companies that are not publicly traded on a stock exchange or invested as part of buyouts of publicly traded companies in order to make them private companies. (Investopedia) In general there are two different options to invest in a company. If the company has gone public you can buy shares of that firm at the public capital market (stock exchange market). This kind of investment is called Public Equity. An investment in a company that is not listed at the public capital market is a Private Equity investment. So the term private is related to the kind of the existing ownership of the companys equity. It doesnt mean that the financing of the investment itself is done by private money or cash. There are some significant differences between the main characteristics of a Public Equity and a Private Equity business. In the form of Public Equity the investor has usually no limitation of the time frame of his investment. He can handle his investments very flexible, which means adjusting his business quite easy in a short term e.g. by buying and selling shares on a day to day basis. Also it is a standard to put investments into different companies or industries. But with this way of investment the investor does not have a big influence and power on the companys daily business and further strategic planning. A public company works like a representative democracy. The designated board of directors monitors and discusses with the Management the companys future and development. The annual meeting is more or less the only way to address an investors opinion to the board of directors. In comparison the Private Equity investment is directly linked to a more entrepreneurial attitude. With such an investment you can be part of the companys management, if you are have operational control, and you can play a part in decisions concerning the future of the companys business. On the other hand this kind of investment is less flexible to rearrange or sell within a short time period. Only if the complete company value has increased it makes sense for the investor to sell his investment.

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Figure 1: Private vs. Public Equity (own illustration based on (Bundesverband Deutscher Kapitalbeteiligungsgesellschafen))

1.2 Private Equity Firms

Especially start-up companies need to raise money for finance growth. Very often the business plans and strategies do not give opportunities to make profit in the short terms which stops banks from giving out necessary loans. Also Private equity firms very often invest in troubled companies. Of course they have to analyze the financial structure and potential of profits carefully upfront to determine if the profit risk ratio makes the investment reasonable. Therefore Private Equity companies are an important tool for driving growth and improving performance for companies that struggle to survive. That can work out, because Private equity owners and the managers of their acquired companies can focus in an accurate way on what is required to improve long-term performance. This structure also makes it far easier to align the interests of owners with those of managers who also have a direct stake in the success of the company. Private equity firms typically hold companies for about five years, and then sell them, hoping to realize a gain on the sale as a result of the increased value they have created during their period of ownership. The general partners cannot recover any of their
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money until and unless they return to investors their principal plus the first eight to 10 percent of partnership profits. If there are no profits, PE partners not only make no money, they lose their own equity investment. (Private Equity Council 2008) The most important Private Equity Companies worldwide today: Apax Partners Apollo Global Management LLC Bain Capital Partners The Blackstone Group The Carlyle Group Hellman & Friedman LLC Kohlberg Kravis Roberts & Co. Madison Dearborn Partners Permira Providence Equity Partners Silver Lake TPG Capital (www.baincapital.com) (www.blackstone.com) (www.carlyle.com) (www.hf.com) (www.kkr.com) (www.mdcp.com) (www.permira.com) (www.provequity.com) (www.silverlake.com) (www.tpg.com) (www.apax.com)

1.3 Private Equity Funds

Private Equity investing can be divided into two main categories: fund investing and company investing. A Private Equity fund is a portfolio of companies established by a Private Equity firm where interested parties can invest in. It is one layer above company investment and for this reason company investment is also called direct investment. Private Equity firms establish funds that raise capital from investors, who are known as limited partners (LP). The Private Equity firm (called: general partner = GP) finally decides to invest this raised capital along with their own capital into companies that they believe can achieve profitability with their infusion of skill and capital. Because one fund is grouping different investments from different kind of investors, PE fund are also called as pooled investment vehicle. Private equity funds are typically limited partnerships with a fixed term of 10 years (often with annual extensions).

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The Private Equity firm is the expert to manage and control each issued Private Equity fund. Also it is there key competence to establish a certain reasonable and balanced portfolio of different funds across certain industries that fit to their particular focus of business.

Figure 2: Private Equity Fund Diagram (How do Private Equity Fund Investments Work? 2010)

The Private Equity target is to create value over the long-term, compared to e.g. hedge funds. Private equity funds typically own and buy whole companies and help them to realize profit growth over time. Typically Private Equity firms own companies in their portfolios for about five years.

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Market size and major trends 2010

In the past few decades, the private equity (PE) industry has grown both in terms of size and geographic reach. In fact, PE has evolved into a major force in global finance over the last 10 years. Roughly US$2.5 trillion of assets are under PE management. However, PE transactions outside North America and Western Europe are still relatively few and only account for approximately 12% of the global LBO (Leveraged Buy-Out) transactions in number and 9% in value over the period from 2001 to 2007. But this is going to change now, recognizing growing PE investment activities into the emerging markets. Without doubt, PE activities in emerging economies are expanding and maturing, particularly for minority and growth capital investments, as stated in a research report by the World Economic Forum in 2008. Taking the growth opportunities within the regions Asia Pacific, Latin America and Middle East (Table 1), there is still an investment backlog in emerging regions compared to the LBO levels in North America and Europe (Figure 3).

Table 1: Real GDP chance (RREEF Research 2009)

Figure 3: Global LBO volume in US$billion by Region, January thru June 2009 (RREEF Research 2009)

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In general, the number of enterprises operating under private equity ownership has grown significantly. In other words, more than 14.000 firms were held worldwide in LBO ownership in 2007, compared to less than 5.000 firms in the year 2000 (World Economic Forum 2008). The worlds best markets for private equity have similar economic characteristics, e.g. stable regulatory environment, liberal policies towards private companies, well-funded financial systems and a focus on entrepreneurship. The major markets of Japan and Europe have performed less well in terms of market growth. But there is an emphasis of private equity firms towards greater investments in Europe and APAC in particular. To maximize the potential of Europe, capital markets and regulatory environment must be integrated genuinely. PE activities will grow slowly in the major emerging markets like Brasilia, Russia, India and China (BRIC-countries) over the next five years, taking the challenging operating environments. From an investor perspective, the PE market is segmented into a primary and a secondary market. Basically, on the primary market private equity firms issue interests of funds they try to establish by raising capital from active institutional and individual investors. By doing so, investors (as limited partner LP) step into a limited partnership with the private equity firm (general partner GP). As of December 31, 2008, private equity firms (managing the PE funds) had approximately $1.5 trillion invested in private companies and $1.0 trillion of unfunded obligations globally (Figure 4, primary market growth). In other words, PE funds have still a lot of dry powder ready to be used for further acquisitions. Investors who find themselves overstretched with their private equity commitments are increasingly tapping into the secondary market for liquidity. Therefore for e.g. optimistic buyers, the secondary market gives considerable opportunities to buy high quality stakes at discounted prices. Already 13% of total fund interests were traded on the secondary market in 2008 (Figure 4). It is expected that the volume of fund interests trading on the secondary market will further increase over the next coming years. It is an option for investors, by trading their fund interests, to exit a limited partnership with the general partner (e.g. private equity firm) when seeking early liquidity or rebalancing the portfolio. However, this kind of transaction is very dependent on the goodwill of the general partner (GP) in order to achieve the best outcome. Furthermore, the secondary market is still much less transparent than the primary private equity fund market.
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Figure 4: Growth of primary and secondary PE market (RREEF Research 2009)

Whats about the Private Equity industry trend in 2010? The Private Equity industry is dominated by a small group of large firms whose core business is buyouts. With their global reach, deep pockets, professional back office operations and sectorial expertise they primarily drive the growth of this industry. Smaller players will be able to find niches in specialist markets and industries, but they do not have a big impact on the private equity industry. However, during the global economic downturn in the years 2008 and 2009, there have been a lot of speculations in the press that the private equity model is dead. But after a phase of reflection and retrenchment there are signs that the private equity industry is shaking off the credit crisis and the economic recession. Many investors appear optimistic about the outlook for private equity again. Credit markets are continuing to stabilize and the deal volume seems to be recovering during the year 2010. However, according to a research of Pricewaterhouse Coopers in late 2009 (Pricewaterhouse-Coopers 2009), over 80% of private equity funds expect the business model to change in the future. Expecting a more robust market for 2010, there will be opportunities for PE firms to make smart acquisitions at bargain prices. However, the past experience of the economic and financial crises has limited the financing options. The request for larger equity contributions will lower the leverage of acquisitions. Politics and society demand for greater transparency and more robust reporting within the private equity industry. Table 2 illustrates a summary of some future trends for the private equity industry.

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IN Liquidity (e.g., liquidity events, available capital)

OUT Illiquidity (e.g., near complete absence of capital for financing or equity investment) More equity in LBOs (e.g., coinvestment capital) Registration, reporting and transparency requirements Secondaries in private equity Emerging markets become more important Shorter duration private equity funds Megacap buyouts Excessive leverage

Table 2: Future trends within private equity (own illustration)

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Types of Private Equity transactions

Private equity transactions can be categorized best by the type of company the investment is made in. Therefore it is helpful to look at the Product Life Cycle, which can be thought of as the hunting ground of each of the main types of Private Equity activity.

Figure 5: Product Life Cycle (Fraser-Sampson 2010, 8)

In other words, the type of Private Equity investment depends on the development stage the company is in. A new company still getting started (Introduction stage) has low cash flows, it not yet well established and investing in it bears a relatively high risk. On the other hand the size of the investment will be relatively low in comparison to investments in grown companies. When a company is for example in the Maturity stage, it is probably well know, already in a strong cash position and will attract and need other investors than companies that are still trying to establish a strong market position in the Growth stage. Keeping the type of company, respectively the stage of development in mind, three main types of Private Equity transactions can be identified: Venture Capital transactions Growth (Expansion) financing transactions Acquisition / Buyout financing transactions In the following chapters we want to look at the different types in more detail. As a short overview, the three main types are compared against each other based on a couple of criteria in Table 3.
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Criterion Companies targeted

Venture Capital Start-up companies, companies in early stages of development Build company, make a business out of ideas, get companies started

Growth Established companies that need to at least stabilize their market position and grow Make companies more profitable, bigger, more valuable; grow company e.g. to go public or be sold Little influence on management, investors role is mainly to provide cash Low risk Mostly not US$5m US$50m

Acquisition / Buyout Mature / established companies

Reason for investing

Buy the company or buy and resell it to other company; going private

Operational control

More guidance than control on management / operations High due to infant mortality Almost never US$50,000 - US$5m

Depends on type of investor: strategic or financial investor

Risk involved Use of leverage Size of investment

Medium to low risk Almost always US$2m US$200m+

Table 3: Comparison of the three main types of Private Equity transactions (own illustration)

3.1 Venture Capital

Venture Capital investments target either start-ups that have just developed an business idea and / or a business plan or young companies that are in their early stages of development and are in need to get started. These companies usually bear strong technological risks, have high R&D expenses or have important investments in equipment, intellectual property and more generally in immobilizations. The main industries VC investments were made in the last couple of years are information technology (IT), life science (LS) and clean technologies. For example venture capital investments in 2008 in Europe were done by 56.8% in the IT sector, by 16.5% in the LS sector. Funding to build a company from scratch with only ideas and a business plan in the back are called seed funding. Seed funding is mostly done by the founders themselves often through securing bank loans against personal collateral, friends, family members or business angels, who specialized in finance innovating start-ups. Business angels are usually former entrepreneurs or executives who turned out to be high net worth individuals. The goal of seed funding is the development of the first business structures
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from ideas and business plans, to gather the initial capital, acquire key human resources and identify early business partners. Seed investing is one of the least favored areas of investing because the death rate of the companies in these stages are relatively high and returns are usually received after a period over more than five years. Seed funding is crucial for businesses because it shapes the future company. To provide innovative ideas and companies a platform for development, many countries try to replicate the Silicon Valley idea by building technoparks (Switzerland) or capuses (UK) where solid infrastructure, a pool of investment and human resources are gathered together. In addition to private investors we have venture capital funds which are formal business entities in which full-time professionals seek out and fund promising ventures. (Megginson et al. 2008, 475) Megginson et al. identify four different types of VC funds: small business investment companies (SBICs; federal charted corporations), financial venture capital funds (subsidiaries of financial institutions), corporate venture capital funds (subsidiaries or stand-alone firms of non-financial corporations, e.g. Intel Capital, Siemens Ventures) and venture capital limited partnerships (funds established by professional venture capital firms). For further details we refer to (Megginson et al. 2008). To minimize the risks of venture capital investments many investors do not only providing financial help but also soft capital. They help the company to find their first customers for pilot projects, try to attract human resources in the company, provide for example qualified lawyers and auditors and give guidance in general management decisions. Investors often form venture syndicates because the different investors have different expertise and know-how. Normally several rounds of financing are needed to help a company to get to a stage where it can survive on its own. Most of investors will provide at least 2 times of the initial investment during the next periods. It depends on the speed of the development and the outlook of the companys future if a next round of funding will be granted or given by the investors. If the company does not move forward as hope, investments will be stopped and the company along with its business idea is very likely sentenced to death.

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But not every start-up company needs venture capital to become successful. For example Microsoft was not venture backed; it was financed through its first customer (IBM). But also the amount / rounds of financing differs strongly between companies: Google needed only 2 rounds of VC financing whereas FedEx needed 10 rounds of financing. Therefore sometimes it is difficult to draw a straight line between Venture Capital investment and Growth Capital investment.

3.2 Growth (Expansion) Capital

Growth, Development or Expansion Capital is generally associated with companies that are well established and already run a profitable business. These companies need capital to expand their business and grow. For example they need to build new plants and increase their level of production, develop new products, research new technologies or want to enter new markets. Many companies in this stage are not granted sufficient bank loans due to their size, their financial records or because banks associate still too high risks with the company. This is where other players enter the game and provide these companies with sufficient financing. In the past it was relatively difficult to identify sources that were specialized on growth capital financing. Most of the time it was LBO fund managers who decided to put money into companies. But over the last couple of years some funds emerged out of industrial groups like 21 Investimenti (Italy) which focused strongly on the mid-market. Also due to the development of the emerging markets more and more companies need this kind of financing and the number of funds specializing in this area of investment increases. Investors of growth capital take minority as well as majority stakes in the investee company. Normally no leverage is used because the target company needs a strong financial position to finance its development. Depending on the success of the company e.g. in gaining market share or enter a new market the revenues from growth capital transactions can vary but will still be relatively low. But also the risk involved can be categorized as low, because the company invested in is already an established company and the chance of failure growth operations is not very high.

3.3 Acquisition / Buyout financing transactions

In general a buyout is considered as the purchase of a company's shares in which the acquiring party gains controlling interest of the targeted firm. (Investopedia) Companies involved in buyouts are usually mature businesses which are able to

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generate sufficient profits to service the debt that is almost always issued in such a transaction (see LBO, page 13). In former times the acquired companies were broken up, sold in pieces and the cash generated was used to pay down the high leverage of the transaction. Nowadays the focus lies more on adding value to the purchased company and using the assets and the profit generated by the development of the company to pay the debt. The level of control taken by the Private Equity investor himself depends on the reason behind the investment. Financial sponsors are only interested in securing the profits and will most certainly not be involved in the management of the target company personally. But to insure the success of their investments they will for example make a deal with the management team to stay on board until the acquisition costs are leveled out. On the other hand, a strategic investor will generally not be interested in keeping the existing management team but will have his team to run operations after the takeover to secure the success of the operation. Buyouts happen for different reasons and in different forms. One main reason for a company can be the wish to go private. Private companies dont need to comply with several restrictions and laws concerning reporting to government institutions and stockholders. This is a way to save a lot of money. Also the management respectively the owners can decide they want to focus more on running and growing the business instead of complying with regulations. We will now have a look at the different forms of buyouts. In comparison to Venture Capital transactions, buyouts cant be carried out without issuing debt due to the size of the financial resources needed to acquire the target company. This is actually one of the main ways in which one can distinguish Buyouts from other forms of Private Equity transactions. Buyouts typically involve only a small portion of Private Equity and a big portion of debt. This is the reason why the term LBO (Leveraged Buyout) is often used for all buyouts. After the transaction, the investors need to make sure that the company works profitable to be able to pay off the debt with revenues generated out of the business. Therefore it is often the case that no matter what special form of buyout happens, there are people involved who bring in their expertise and advise the target company on how to generate sufficient profits. Actors in the LBO

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market are large Private Equity firms like the Blackstone Group1. Some of them have also listed their funds like KKR2. The different players in the LBO market are merely specialized either on the size of the target companies and / or on the industries the companies are operating in. A special form of an LBO is the Management Buyout (MBO) which will be discussed in detail in Chapter 4. It basically means that the management team of a company or parts of it, who have previously held a limited equity stake or no shareholding at all, decide to acquire the company either from the parent company or from shareholders. MBOs can arise out of a variety of reasons e.g. in case of a family business where there are no obvious successors to take over the company. Another reason might be that the company wants to restructure and get rid of a certain subsidiary which is then be acquired by the management team. Historically these transactions were done by the new owners themselves. However, in the last years it became more popular to involve private equity firms to approach the target company and involve the new owners only at the end of the acquisition process. Another form of buyout is the Management Buy-in (MBI) which differs from the MBO only in terms of the management team. The new owners were previous to the transaction not a part of the management group and bought their way in. Individuals (mostly people who were involved in MBOs earlier on) interested in MBIs are most of the time from the same industry as the target company and therefore have the necessary expertise in the area the company operates in which reduces the risk of such a transaction.

3.4 Other types of transactions

There are a lot of other types of private equity transactions and their categorization is not consistent through literature. Nevertheless, the two types presented in this chapter are the most relevant ones looking at the market.

1 2

http://www.blackstone.com http://www.kkr.com

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3.4.1

Secondary buyouts

A secondary buyout describes a transaction where an existing company created as a consequence of a buyout backed by original private equity investors is sold to a new buyer vehicle backed by new private equity investors. (Yates et al. 2010) Even though private equity funds are mostly considered an illiquid investment they can be turned liquid through secondary buyouts. For example if a PE investor wants to sell his part in the investee company there is significant number of secondary investors who will take over this part. Of course this depends on the attractiveness of the investment proposed. The market for secondary buyouts was not too strong a couple of years ago but has increased over the last years. 3.4.2 Mezzanine Financing

Mezzanine finance got its name from its position on the balance sheet where it is located between senior debt and equity. Another form of PE financing is Mezzanine financing, which is strongly connected to buyouts. A mezzanine investor will lend money into a Buyout transaction, but with the right to convert all or part of it into shares in the target company. (Fraser-Sampson 2010) This type of financing can be used for example to bridge the gap where senior creditors are reluctant to extend the debt and stockholders are reluctant to accept the dilution of their equity position. There is a wide area of mezzanine lenders which include insurance companies, mezzanine funds, venture capital firms or banks and other senior lenders.

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A typical MBO process

As defined in the previous chapter, MBO is a special form of a LBO in which the existing Management team decides to acquire the company, usually in cooperation with outside financiers. This acquisition process, which differs in some aspects from other LBO-forms, will be described in the following by focusing on the participants as well as on the organizational and financial flows. Normally, the MBO is initiated by the Management Team3 who addresses its purchase interest towards the current owner (letter of intent). The advantage of a MBO is the existing knowledge of the Management about the companys performance. This makes the Due Diligence process less complicated and hence faster. The skills and the knowledge of the management is one key success factor. The acquisition of the company (also called Target) is normally financed by a third party as it is highly unlikely that the Management will have sufficient funds themselves to buy the Target due to the high purchase price. In almost all buyouts, finance from external sources will be required. Debt financing often covers only a small part of the investment, as MBOs are considered too risky for a bank to give out loans. Thus, the management seeks for private equity investors instead who invest for a proportion of the shares. For the investors it is important to make sure that the Management is locked-in by its own investments. In this way, the risk of inappropriate management decisions can be minimized. It is likely that the managements shares of the company increase in order to maintain the managements motivation to maximize the company value. The following illustration visualizes the correlations between the participants in more detail.

In some cases, the initiation derives from the current owner who intends to sell the company. Private Equity

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Figure 6: The MBO-Participants and their roles (own illustration based on (Manches LLP))

The MBO-process is not consistently described through literature. However, the most important phases can be categorized as Preparation, Transaction and Completion phase. As mentioned before the MBO is initiated by the announcement of the offer, normally in an informal way. During this preparation phase, negotiations about purchase price and contracts already between seller and buyer begin. The management team starts elaborating the Financing-Structure in order to define the most suitable balance between Debt and Equity Finance in consideration of expected cash flows and risk. The preparation of a Business Plan is an important tool to catch the attention of potential investors. The management sets up a MBO-Team with key players within the company who leads the MBO-process. After selecting equity advisors who are crucial as external experts for such a complex topic regarding taxation, legislation and finance, the transaction process begins. During this second phase, the Shareholders Agreement is signed. This is the deal between the private equity provider and the management relating to their subscription for shares in, and the managements' employment by the new company. The second deal is the Sales Contract between Newco and the seller for the acquisition of Target. Third agreements, so called Loan Agreements, are those between Newco and the providers of finance for the acquisition of Target.

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In the completion phase the Due Diligence starts. This process, however, is likely to be limited as buyers have already full knowledge of the company. Thus, there is no Principal-Agent issue, which is typical of other LBO-transactions. This is also a reason why the seller often prefers MBO as exit strategy as it is less time consuming. The following illustration describes these 3 phases and each single step in more detail.

Figure 7: Organizational and financial flow of a MBA-process (own illustration based on (Manches LLP) and (Hoffmann et al. 1992, 68))

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Private equity as a financing source

The idea of Private Equity is relative simple and theoretically quite effective4: buying underperforming companies, or companies that have found their critical mass to continue growing, turning them round and selling on at a profit (Private equity takeovers 2007), looks to be the right solution in order to eliminate inefficiency and maximize value. By doing so, they create more financial wealth, and not only for their own investors, but also (at least theoretically) for those companies that are being acquired. The central question raised by Private Equity as a financing source is: Do PE investments aggregate growth and stability in terms of value creation or is it just a financial tool to make short-term profit for the Private Equity firms point of view? Or in other words: Are Private Equity firms only concerned to secure a high and fast return on their investment? Private capital is now center in the on-going examination of the global financial system, especially since the recent financial crisis5, with a consequent interest of policy-makers to understand the impact of both traditional financial institutions, such as banks and insurance companies, and alternative investment asset classes, such as private equity and venture capital, on the global economy. The World Economic Forum (WEF) publishes a report on the global economic impact of the PE seeing it as a financing activity every year. They analyze the consequences of this relative new financing source for those companies who decide to use it. The WEF have defined the outcome of the overall PE activities in few fields to understand the effects of it as investing activity: Management Performance, Productivity, Strategically portfolio, Risk sharing", etc. (The Global Economic Impact of Private Equity Report 2009) As financing activity, we could also analyze the following points as well: the impact of Private Equity on innovation, employment and corporate governance.

Venture capital financing is not considered in this paragraph. Here it is important to understand that several of these PE firms normally use traditional financing sources. They provide at the end only 15 or 20 per cent of the company capital and the rest is brought in by banks. The debts are then finally transferred traditionally to the acquired enterprises.
5

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5.1 Key findings on Productivity and Management performance

1. Firms acquired by private equity groups experience productivity growth in the twoyear period after the transaction. 2. The roughly 1,400 private equity transactions involving US manufacturing firms from 1980 to 2005 raised output by somewhere between US$ 4 billion and US$ 15 billion per year as of 2007 3. Both targets and controls tend to share productivity gains with workers in the form of higher wages 4. Private equity-owned firms are associated with high scores on a wide range of management practices, especially operational management practices. (The Global Economic Impact of Private Equity Report 2009, VII)

Figure 8: Private equity-owned firms have the best raw management practice scores on average (The Global Economic Impact of Private Equity Report 2009, 11)

As a critical counter argument, it could be said, that the difference in management practice scores between Private Equity and dispersed shareholding firms (including publicly quoted firms) is insignificant, and that normally PE firms select

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underperforming companies, so this incremental in productivity as well as in the management performance should not be surprising but expectable.

5.2 Key findings on Strategic Portfolio and continuity

If we have a look at Patent quantity, we can see that it does not change after PE transactions. The patent portfolios of firms become even more focused in the years after PE investments. It is said that PE firms display no social responsibility; they have no interest in investing in training or plants, since such investments are costly and rewards are deferred and they do not have a long term view concerning their investments. Empirically, if we look into the patent quantity from the companies before and after the acquisition, it is clear that the portfolios of firms become even more focused in the years after the PE investments. That would not be the case in short term strategies but more for long term views. It is true that many times PE firms generate profits by sacrificing necessary long-run investments, but those are being compensated for the complete portfolio leverage. Short-termism has been the curse of many. PE finance, being geared to quick profits, perpetuates this failing by discouraging long-term planning (Private equity takeovers 2007). But the so called quick flips (i.e. exits within two years of investment by private equity fund) account only for 12% of deals and have decreased in the last few years. However, they could be a reason of the bad reputation of PE. The reality shows a different tendency: PE investors have a long-term ownership bias. 58% of the private equity funds investments are exited more than five years after the initial transaction (The Global Economic Impact of Private Equity Report 2009).

5.3 Key findings on employment

While it is true that many of the PE acquisitions may include job destruction in the short term, it is on the other hand also apparent that inefficiency damages the companys financial situation and finally leads to unemployment on a much greater scale (see Figure 9). PE firms display no social responsibility and they main task is to eager a profit in their transactions; as financing activity, it must be clear that the governance of the company gets diluted and many of strategically decisions, also regarding employment management normally get out of the control of the former owner.
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Figure 9: Manufacturing employment under private equity targets: year and as percentage of manufacturing sector employment (The Global Economic Impact of Private Equity Report 2009, 39)

In general it can be said that there are certain inherent risks by using Private Equity as an alternative financing source to the traditional debt acquisition as i.e. using loans from banks. On the one hand introducing an active partner who can share ownership, financial and management responsibilities can lead to a better company performance and generation of profits. On the other hand it has to be understand, that the majority of PE activities in the past led to a total control of the management activities and to a dilution of the firm control.

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5.4 Summary of Pros and Cons on the PE as financing activity:

Summarizing the previous chapters, the arguments for and against private equity as a financing source are listed in the following table. Pros Introducing an active partner who can share ownership and management responsibilities Share financial responsibility with other. Finance growth without increasing personal debt Overcome the critical mass and greater security for growth Inefficient companies damages the financial situation on the company and finally leads to unemployment PE investments make companies more productive PE firms are significantly better managed than government-owned, family-owned and privately owned firms Value-added implied by the differential in productivity PE investors have a long-term ownership bias. Cons You are accountable to other parties

Control over the business and access to the CF is diluted

Diluted control of your business

Restructuration may involve job losses

PE firms display no social responsibility Normally PE firms seem to select underperforming firms

Short-term financial goals at the expense of operating performance. Main focus is to generate profits. Some PE firms have only short term focus

Table 4: Pros and cons of PE as an alternative financing source (own illustration)

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Bibliography
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Loiacono, S. (n.d.). Private Equity A Trendsetter For Stocks. Retrieved May 22, 2010, from Investopedia: http://www.investopedia.com/printable.asp?a=/articles/07/privateequity.asp Ltjen, G. (1992). Management Buy-Out: Firmenbernahme durch Management und Belegschaft. Wiesbaden. Manches LLP. (n.d.). Retrieved June 04, 2010, from http://www.manches.com Marks, K. H., Robbins, L. E., Fernndez, G., Funkhouser, J. P. (2005). The Handbook of Financing Growths: strategies and capital structure. Hoboken, New Jersey. Megginson, W., Smart, S., Lucey, B. (2008). Introduction to Corporate Finance. London. Pricewaterhouse-Coopers. (2009). Private Equity Trend Report 2009. Frankfurt: Pricewaterhouse Coopers. Private Equity Council. (2008, July). Retrieved May 12, 2010, from http://www.privateequitycouncil.org/ Private equity takeovers. (2007, February 26). Retrieved May 20, 2010, from The First Post: http://www.thefirstpost.co.uk/5104,news-comment,news-politics,pros-and-consof-private-equity-takeovers RREEF Research. (2009). The Outlook for Private Equity Second Quarter 2009. San Francisco, USA. The Global Economic Impact of Private Equity Report 2009 - Globalization of Alternative Investments, Working papers Vol.2. (2009, January). Retrieved May 21, 2010, from World Economic Forum: http://www.weforum.org/pdf/cgi/pe/Full_Report2.pdf Tuck Center for Private Equity and Entrepreneurship. (n.d.). Retrieved May 23, 2010, from Tuck School of Business at Dartmouth: http://mba.tuck.dartmouth.edu/pecenter/about/index.html Value Based Management.net. (2010, March 29). Retrieved June 13, 2010, from www.valuebasedmanagement.net

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World Economic Forum. (2008). The Global Economic Impact of Private Equity Report 2008. Geneva, Switzerland: World Economic Forum. Yates, G., Hinchliffe, M. (2010). A practical guide to private equity transactions. Cambridge.

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Appendix

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Figure 10: Private Equity Landscape Chart (Tuck Center for Private Equity and Entrepreneurship)

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