Private Equity Explained

7/28/2019 Private Equity Explained

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Presentation Aims

1) A Definition of Private Equity, along with GeneralCharacteristics

2) Mechanics of a Private Equity Deal

3) Risk-Return Profile4) Comparisons of Private Equity to other Investment

Types

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General Characteristics

Shares held not publicly traded

Distinguishing

Parameters:

Illiquid, long term investment

Limited Partnerships with Active Ownership


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Magnitude and Scope

$211 billion in mergers and acquisitions

The total dollar amount exceeds $5.7 trillion

Private Equity accounts for 54%

of all mergers and acquisitions

MGM Buy Out for $3 Billion


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Player Interaction

Private CompaniesPE Firm / FundInvestors


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Investors to PE FirmInteraction

Insurance

Banks

University Endowments

Pension Funds (Gov)

Private CompaniesPE Firm / Fund

Investment in PEFund

Return onInvestment

In

stitutional Investors


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The InvestorsWho invests in PE?

How much do these investors put into the fund?

Big groups with a lot of money

Examples:

Pension Funds


Banks

Insurance Agencies

A large sum of money, on the order of millions.


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Investing

How then does one invest?

This million dollar investment is placed into a Private Equity Fund, which ismanaged by a Private Equity Firm

PE Firm / FundInvestors

The Private Equity Firm will then decide how to

manage and allocate the funds for the investors.


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PE Firm to CompanyInteraction

Insurance

Banks


Pension Funds (Gov)

Private CompaniesPE Firm / Fund

OwnershipManagement

Advising

Increased equity(Return on

Equity)

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Increasing Equity

Debt, $80,000 Debt, 80,000

Equity, 120,000

Equity, $20,000

INVESTMENT FUTURE

Ownership is worth $20,000,Value of company is $100,000

Ownership is worth $120,000,Value of company is $200,000

Over timeEnterpriseVa

lue


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Mechanics of Investment

A Mixture of BothIncrease Value Pay off Debt

Equity = Enterprise Value Debt


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Firm Specialization

Private Equity Firms specialize in:

economic sector

target firm size

investment styles

Overall fund portfolios reflect this preference.

Small-cap, Mid-Cap,

Large-Cap

Healthcare, Multimedia,

Communications

Private Equity Funds invest in a portfolio of 20-25

companies based on their expertise.


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Expansion Financing Financing for expanding business operations

Acquisition/Consolidation Securing absentee-owned or publicly-traded

companies

Turnaround Financing reworking under-managed, distressed companies torestore them to

profitability

Leveraged Buy-Outs (LBOs) restructuring the level of equity versus debt

Types of Deals


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Use of Leverage

Private Equity firms help bidders purchase equity shares at a

premium this transaction is financed by debt

This mechanism allows for therestructuring of the debt to equity ratio of a

company

Leveraged Buy-Outs

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bondsbonds

It also sometimes serves as a defensivemaneuver by management that thwarts

hostile takeovers

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These are taken out againstthe current value and

expected cash flows of thecompany.


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Company Incentives

1) exchange ownership (equity) for cashmoney ($$)2) use $$ to buy a competitor, grow abusiness,

finance operations, etc.3) Gain managerial mentorship4) Equity is not diluted through publicoffering

Whats in it for the Companies?


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Risk/Return

Risk and Return Information on

Private Equity Investing


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PE Firm Control of

Risk

Firms use hedging/portfolio theory to reduce risks

Large ownership stakes mean that the PE fundcanmanipulate each firms management and

operations.

Private Equity firms have some controlover risk:


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Investor Risk/Return

Private Equity Risks and Returns Depend on:

Financial setup employed (i.e. majority/minority positioning)

Skill of fund management (blind pool investing)

Interest rate trends and other externalities

Illiquidity of investment

Extent of private information

Degree of concentration in a fund portfolio (portfolios are not well

diversified

Other elements that add to risk:


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Returns

IRRs are usually negative at the beginning of investment

IRRs only start becoming positive around the 7th year of investment

Due to this characteristic, only the final IRR on a

fund is a meaningful measurement

IRRs change over the life of a fund

Private Equity returns are measured asInternal Rates of Return (IRR)


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Returns

With Actual Numbers:

The final Internal Rate of Return (IRR) on amature Private Equity fund averages

~20%*This represents a 6% return over investing inthe S&P500 through the same time period

*net of carried interest and management fees therefore this is the actual return to the Limited Partner

Source: Ljungqvist and Richardson

Overall, an investor can anticipate a margin of performance that

outperforms the public market

this counterbalances the intrinsic shortcomings of the illiquid,

blind-pool investing traits of Private Equity


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Risk Comparison

What does Private Equity investment entail?

Overall, the risk of Private Equityinvestments is higher than that of

stocks and bonds, but lower than thatof Venture Capital

less riskmore risk

High expected returnsA long horizon (10+ years!)Higher risk as compared to stocks or bonds

Bonds

Stocks

Private Equity

Venturecapital

R l i O h


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Relation to OtherAssets

Ownership held by investors of Private Equity is not available to the

general public.

PrivateEquity

vs.

When compared to stocks, Private Equity has a higher average

return coupled with a higher risk.

Private Equity fund managers are actively involved in management

of companies that they have a stake in this is not true for stocks

Stocks

R l ti t Oth


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Firms that make a Private Equity deal exchange ownership for

immediate funds.

PrivateEquity

vs.

Firms that issue bonds exchange immediate funds for later payments.

Bonds

Bonds are debt financingwhile Private Equity is equity financing.

R l ti t Oth


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PE Markets are more stable

PE firms interact with seasoned management teams

In PE, there is less exposure to technological change and disruption

PrivateEquity

vs.Venture Capital

The major difference is in the timing of the investmentVenture involves financing of young, private enterprises

Private Equity is the investment in established businesses


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InteractionsHow does Private Equity relate to other Investment

Classes?

Private EquityVenture Capital

tocks (public equity)

Debt (Bonds)


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Why Invest in PE?

Why Private Equity is an attractive investment:Why Private Equity is an attractive investment:

Superior real rate of return*

funds characteristically generate a 56% premium over the expected returns formarketable equities

Less than proportionate risk increase* The large increase in return is well worth the small increase in risk

Low correlation with public equity or

fixed-income returns

PE investment is therefore excellent for portfolio diversification*as compared to public equities


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Takeaway Points

1) PE = Private Equity firms investing inCompanies

2) Three Players: Institutional Investors, PEFirms,

Companies

3) Investment make money by increasing equity over

time.

4) Fund Portfolios generate an average IRRof 20%,

but incur substantial risk.

Documents

Private Equity Explained