Private Equity: A Casebook

By Paul Gompers, Victoria Ivashina and Richard Ruback

’Private Equity’ is an advanced applied corporate finance book with a mixture of chapters devoted to exploring a range of topics from a private equity investor’s perspective. The goal is to understand why and which practices are likely to deliver sustained profitability in the future. The book is a collection of cases based on actual investment decisions at different stages for process tackled by experienced industry professionals. The majority of the chapters deal with growth equity and buyout investments. However, a range of size targets and investments in different geographical markets are covered as well. These markets include several developed economies and emerging markets like China, Russia, Turkey, Egypt and Argentina. This compilation of cases is rich in institutional details, information about different markets, and segments of the industry as well as different players and their investment practices – it is a unique insight into the key alternative asset class.

• Language: English
• Publisher: Anthem Press
• Release date: Mar 15, 2019
• ISBN: 9781783089185

Book preview

Advance Praise for Private Equity

It has been difficult for students and practitioners to find good material on investing in private equity. Until now! In this book, Gompers, Ivashina, and Ruback have compiled exciting and clearly written cases and notes on sourcing, valuing, structuring, and managing private equity investments.

—Steven Neil Kaplan, Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance, University of Chicago Booth School of Business

Professors Gompers, Ivashina, and Ruback have compiled an insightful, thorough, and useful compendium of private equity techniques from valuation to structuring to firm management. The thoughtful practitioner will enjoy having this book not only as a reference but also as an opportunity to review case studies where theory is put into practice.

—Michael S. Berk, Managing Director, TA Associates

Professors Gompers, Ivashina, and Ruback bring forth the depth and complexity of the growth equity and private equity deal-making process from the real-life perspectives of important industry participants. The professors’ structured view of the often unstructured and intuitive world of these risk capital providers makes this casebook an essential tool for educators, researchers, and others with a professional interest in the industry.

—Bruce R. Evans, Senior Advisor, Former Managing Director, Summit Partners

The incisive detail of each case brings alive the complex considerations, both financial and human, that are critical to investment value creation. As we all must embrace continuing education, this is an excellent book for investors, practitioners and students alike. After all, the day we believe we have nothing further to learn is the day we become fools.

—Dominique Senequier, President, Ardian

I have been an enthusiastic user of the authors’ cases for several years now. This compilation, supplemented with several new cases and very useful teaching notes on PE techniques and concepts, is a great resource for anyone wanting to teach a comprehensive and up-to-date course on private equity. PE has come a long way since the ‘Barbarians at the gate’ of the 1980s, and this volume provides a rich and balanced view of the exciting new world of private equity investing.

—Per Strömberg, SSE Centennial Professor of Finance and Private Equity, Swedish House of Finance

"Private Equity is an invaluable tool for understanding how private equity investors conduct their craft with many real-life lessons to draw upon for new and emerging practitioners. The authors provide a road map for learning from many of the premier private equity firms and their landmark deals as well as insights on how the firms themselves execute the continuity of their business."

—Darren Black, Managing Director, Summit Partners

A fabulous resource for the aspiring private equity investment professional. Gompers, Ivashina, and Ruback strike a marvelous balance of being comprehensive, pragmatic, and nuanced without being overly technical or academic. I wish this book had been around when I was starting out––it would have definitely turbocharged my understanding of how to approach potential opportunities and what makes successful private equity deals work.

—Andrew S. Janower, Managing Director, Charlesbank

Private equity investing is both an art and a science, and certain investors appear to just have a ‘knack’ for picking winners. But this belies the discipline, diligence, and consistently strong processes that almost always inform such successful investors’ wise decisions. Gompers, Ivashina, and Ruback use compelling real-world examples to demonstrate the importance of such discipline throughout the ‘life cycle’ of successful private market transactions and provide the reader with many tools to develop their investment edge.

—Neil Wallack, Founder and Managing Director, 1901 Partners

Private equity is becoming a fundamental topic in finance. Understanding the way in which private equity deals can create value is becoming a necessity for every good MBA student. This casebook provides the basis for a course that illustrates the private equity model from fundraising to exiting.

—Michael Weisbach, Ralph W. Kurtz Professor of Finance, Ohio State University

Private Equity

Private Equity

A Casebook

Paul A. Gompers,

Victoria Ivashina

and Richard S. Ruback

Anthem Press

An imprint of Wimbledon Publishing Company

www.anthempress.com

This edition first published in UK and USA 2019

by ANTHEM PRESS

75–76 Blackfriars Road, London SE1 8HA, UK

or PO Box 9779, London SW19 7ZG, UK

and

244 Madison Ave #116, New York, NY 10016, USA

Copyright © Paul A. Gompers, Victoria Ivashina and Richard S. Ruback 2019

The authors assert the moral right to be identified as the authors of this work.

All rights reserved. Without limiting the rights under copyright reserved above,

no part of this publication may be reproduced, stored or introduced into

a retrieval system, or transmitted, in any form or by any means

(electronic, mechanical, photocopying, recording or otherwise),

without the prior written permission of both the copyright

owner and the above publisher of this book.

British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library.

ISBN-13: 978-1-78308-916-1 (Hbk)

ISBN-10: 1-78308-916-4 (Hbk)

This title is also available as an e-book.

Contents

Preface

Introduction to Private Equity Finance

Private Equity Finance Vignettes: 2016

Section 1: Deal Sourcing and Evaluation

Chapter 1.1A Note on Valuation in Private Equity

Chapter 1.2A Note on Capital Cash Flow Valuation

Chapter 1.3RJR Nabisco

Chapter 1.4HCA, Inc. (A)

Chapter 1.5HCA, Inc. (B)

Chapter 1.6Summit Partners—The FleetCor Investment (A)

Chapter 1.7Summit Partners—The FleetCor Investment (C)

Chapter 1.8Private Equity Valuation in Emerging Markets

Chapter 1.9The Abraaj Group and the Acibadem Healthcare Investment (A)

Chapter 1.10United Capital Partners (A)

Section 2: Deal Execution and Structuring

Chapter 2.1United Capital Partners (B)

Chapter 2.2Qalaa Holdings and the Egyptian Refining Company

Chapter 2.3Berkshire Partners: Party City

Chapter 2.4Hudson Manufacturing Company

Chapter 2.5Note on LBO Capital Structure

Chapter 2.6HgCapital and the Visma Transaction (A)

Chapter 2.7HgCapital and the Visma Transaction (B-1): Nic Humphries

Chapter 2.8HgCapital and the Visma Transaction (B-2): Oystein Moan

Chapter 2.9Note on the Leveraged Loan Market

Chapter 2.10Harrah’s Entertainment

Chapter 2.11Charter Communications’ Bankruptcy

Chapter 2.12Blackstone and the Sale of Citigroup’s Loan Portfolio

Section 3: Deal Management

Chapter 3.1AXA Private Equity: The Diana Investment

Chapter 3.2Momentive Performance Materials, Inc.

Chapter 3.3Bain Capital: Outback Steakhouse

Chapter 3.4BC Partners: Gruppo Coin

Chapter 3.5Advantage Partners: Dia Kanri (A)

Chapter 3.6TPG China: Daphne International

Section 4: Realizations

Chapter 4.1Private Equity Exits

Chapter 4.2Housatonic Partners—ArchivesOne, Inc.

Chapter 4.3Ardian—The Sale of Diana

Chapter 4.4A Note on the Initial Public Offering Process

Chapter 4.5Knoll Furniture: Going Public

Chapter 4.6Globant: Going Public

Chapter 4.7HCA, Inc., LBO Exit

Section 5: Private Equity Firm Strategy and Management

Chapter 5.1DW Healthcare Partners

Chapter 5.2ABRY Fund V

Index

Preface

This book is a collection of cases that have been used in Private Equity Finance, an advanced corporate finance course offered in the second year of the Harvard Business School’s MBA curriculum, over several years. The goal of the book (and the course) is to provide a detailed insight into the sources of value creation and the process of the dealmaking in the growth equity and buyout spaces of the private equity industry. Most of the cases are written from the perspective of the investor, or general partner. Each case in this book is based on actual investment decisions tackled by experienced industry professionals.

As explained in the first chapter, the structure of the book follows the timeline of a private equity investment. It begins with deal sourcing, assessment, and valuation and moves on to deal structuring and active management of the operations and the capital structure. Finite horizon of an investment—about five years on average, a standard time line in a typical valuation exercise—is one of the defining characteristics of the private equity asset class. Thus, the discussion of the dealmaking process will conclude with a set of cases and notes on private equity realizations. The final chapter of this book will take a step back and reflect on the economics of a private equity firm.

Most of the cases will be concerning growth equity and buyout investments. However, the cases will cover a range of size targets and investments in different geographical markets. These markets include several developed economies, but also emerging markets like China, Russia, Turkey, Egypt, and Argentina.

This is an advanced book. An opening note, Introduction to Private Equity Finance, will outline some basic concepts about private equity that will be helpful to navigate through the rest of the book. In addition, the book includes several sections that dive into specific topics in depth. This includes sections focused on valuation techniques, a section on the leveraged loan market, a section on capital structure used in private equity transactions, and several sections related to exit from private equity transactions. While being self-contained, the book will advance at a fast pace.

It should be noted that Harvard Business School cases are anchored around specific decisions. They are designed to communicate the complexity of the real-life decision-making while highlighting elements that go into the decision process. The class discussion on cases is an important part of the learning process. Thus, this is ultimately not a how-to book. However, the cases compiled here are rich in institutional details, information about different markets and segments of the industry as well as different players and their investment practices. Educators looking to adopt some of these cases in their course can find additional resources through Harvard Business Publishing that will help them effectively structure the class discussion. For readers looking to understand the private equity better, our advice is to approach this compilation as a unique and comprehensive insight into the industry’s practices with many exhibits and narratives reflecting approaches used by the actual players.

Introduction to Private Equity Finance

Structure of Private Equity Finance

Private Equity Finance (PEF) explores the aspects of corporate finance that are central to the private equity industry. While the course provides tools critical to effective investing in private equity, the concepts explored have broad applicability to other corporate settings. The issues of valuation, financing and capital structure, operational improvements and deal management, and value realization are central to all organizations. PEF examines these issues in the context of a private equity organization. While the course provides essential tools, skills and industry knowledge to students planning to pursue a career in private equity, the in-depth examination of corporate finance makes the course appropriate for any student seeking an advanced understanding of these topics.

Private equity investors seek to generate attractive returns for their investors by executing well-developed strategies. These investors hope to generate returns in excess of the risk they bear through a variety of means. In general, there are three ways in which private equity investors could, at least in theory, generate positive risk-adjusted returns for their investors: multiple expansion, leverage and operational improvements.

Multiple expansion is the process of buying a given dollar of cash flow at a lower valuation than you ultimately sell it for in the future. Many private equity firms seek proprietary deals that allow them to buy assets at a cost less than they can sell them to strategic acquirers or the public market in the future. During the 2000s leveraged buyout (LBO) boom, rising public market multiples provided opportunities for private equity investors to buy companies, hold onto them for a time and then sell them when market multiples increased. The sustainability of executing a private equity program based upon multiple expansion, however, is subject to competition and general market cycles.

Leverage can also improve returns, but it typically does so only by increasing the underlying cash flow risk of the company—that is, leverage is not a free lunch. If private equity firms can time debt markets when interest rates are advantageous, then the firms can generate value through leverage. Private equity firms may be able to generate substantial returns from leverage when debt markets are accommodating, as they were in the 2003–7 time frame. Additionally, the high leverage can create debt tax shields that increase value. The ability to generate returns via leverage, however, is also subject to external market conditions and the receptivity of debt providers to leveraged transactions.

Finally, private equity investors often focus on operational improvements. Many private equity firms institute detailed operational plans based upon their own (or their outside consultants’ and affiliates’) expertise in operations. Going forward, operational improvements are likely to be the most important source of future returns in private equity. One element that we will explore is why these advantages are sustainable and unlikely to be competed away in the future.

PEF is organized into five modules around the life cycle of an investment. Module 1, Deal Evaluation, examines the investment decision/evaluation. In this module we will examine important financial tools and ideas. Valuation is a central concept in Module 1. We will examine and compare a variety of valuation methodologies including discounted cash flow, multiples and LBO valuation methods. We will explore these issues in a variety of settings including very small LBOs and growth equity investing, large LBOs, as well as the unique issues facing valuation in emerging private equity markets.

Module 1 will also examine important due diligence issues. How do you identify the key drivers of investment decisions? What would you want to know in order to validate valuation and/or projections? How can you classify risks into knowable and unknowable risks, and what are the risks you can control? The time, money and effort spent by private equity firms researching investments demonstrate the critical role of due diligence.

Module 2, Deal Execution, examines the critical features of structuring private equity transactions. Module 2 highlights the complex nature of private equity deals. Holding companies, operating companies, property companies and so on are all common features of private equity deals. Private equity investors must evaluate incentives of managers and stakeholders and must design corporate governance that aligns the incentives of all parties. Tax implications are often important and need to be fully examined as well. Capital structure choices are central to deal execution as well. We will explore loan and bond contracts in detail to assess how and why financing is structured in various transactions. Covenants, reps and warranties, and a variety of debt contract provisions, will be dissected to fully understand the critical importance of debt providers and debt markets.

Module 3, Deal Management, explores the decisions private equity investors make subsequent to investment that are necessary for enhancing value. Operational issues will be central to this module, and understanding key operating levers will be evaluated. Similarly, not all private equity investments go as planned. Many require restructuring of one form or another. Module 3 provides an opportunity to examine the tough choices that private equity firms must often make.

Without ultimately liquidating their holdings, private equity investors cannot generate returns for their investors. The limited-partnership nature of funds that typically require return of capital by the end of 10 years forces the private equity investors to plan for an exit even before the investment is consummated. Module 4, Realizing Value, examines the variety of methods that private equity firms utilize to generate returns. Initial public offerings, strategic sales and leverage recapitalizations are all important vehicles for realizing returns.

Finally, in Module 5, Strategic Issues in Private Equity, we move to examine broader issues for private equity managers. Relations between general and limited partners, fundraising decisions, recruiting and career management issues are important elements of creating successful private equity organizations. We will highlight some of these issues in the final module of the course.

Introduction to Private Equity

This course explores the financial issues related to the private equity industry. The term "private equity investment" in the most general sense means investments in equities (stock) of companies that are not traded on stock exchanges—and therefore are not available for investment by the general public. Private equity firms are financial intermediaries that help investors (usually large institutional investors) make private equity investments by contributing capital to funds established by private equity firms. The key elements of private equity investing rely on careful assessment of valuation, capital structure and corporate governance. By examining these issues through the lens of private equity investors, this course will provide you with a richer understanding of the tools of corporate finance.

Private equity firms invest in venture capital (investing in young entrepreneurial companies), mezzanine capital (preferred equity investments senior to common stock, typically raised by smaller companies), growth capital (large but usually minority investments in stock of relatively large companies), leveraged buyouts (discussed below) and distressed investments (investing in securities of companies in bankruptcy or close to it). The private equity industry started in the 1940s when the first venture capital funds were formed. Buyout funds emerged as an outgrowth of venture capital firms in later years and share a common structure, compensation and investor base. The industry practices in many respects stem from the venture capital industry’s practices that developed during the early stages of the industry’s evolution.

The defining characteristics of private equity firms include the following:

• Investments made by private equity firms are generally illiquid because of the nature of the investments.

• Private equity firms take an active role in monitoring and managing portfolio companies.

• The primary goal is to maximize the financial return through profitable exit opportunities and dividends. ¹

This course will examine the financial issues relating to private equity investing. The course will follow the life cycle of a typical private equity investment.

Leveraged Buyouts

In a typical leveraged buyout transaction, a private equity firm buys the majority control of a mature firm from existing public or private shareholders (hence the buyout). The company that is being bought out is often referred to as a target company or target of the LBO. Many LBO targets are public companies; that is, their stock is traded on one of the stock exchanges and can be owned by the general public (although private equity firms also buy private companies and divisions of both private and public companies). These transactions are also referred to as going private because after the LBO, the stock ceases trading on an organized exchange and is owned by the acquirers. Private equity firms acquiring a company in an LBO are also often called sponsors of an LBO.

Bharath and Dittmar report that 1,377 U.S. firms went private between 1980 and 2004,² even before the LBO boom of 2006−7. Companies choose to become private for different reasons including information, agency and control considerations, as well as liquidity and access to capital.³ Some practical disadvantages of being public include the costs of regulatory compliance and the market’s focus on short-term earnings rather than long-term strategy. Management scholars have written that the improvement of incentive alignment and the presence of a large outside shareholder improves the performance of private equity–financed companies. Numerous studies have shown that private equity–backed companies tend to grow more quickly, add jobs quicker than their industry peers and are more innovative.⁴

Private equity firms usually finance only a small portion (10−40 percent⁵) of the purchase price with their own (equity) capital and borrow the rest from banks that specialize in LBO financing, funds that specialize in providing debt capital for buyouts (mezzanine funds) or debt capital markets. This borrowing to finance a deal is called leveraging equity capital, hence leveraged buyout. The amount of leverage available in any given transaction changes based on a variety of factors, including the industry, the business cycle of that industry, the availability of capital (generally) and the projected earnings of the target.

Because private equity firms are concerned about the target’s ability to pay the interest and principal on this large debt, they prefer that buyout targets have relatively low existing debt, a history of large and stable cash flows, potential for operational improvements (such as cost cutting) and industry-, market- and company-specific conditions that result in a lower current market price but can be expected to reverse in the future. Much of the value creation from LBOs is dependent upon the private equity firms’ ability to create tax shields from the large increase in interest payments.

In other respects, an LBO is similar to any sale of a company. Although private equity firms often approach attractive targets and inquire about their interest in going private, many targets initiate the process themselves, and the decision to start a sale process is always the target company’s decision. Just as with any sale of a company, some LBOs are arranged through auctions and some are proprietary deals—that is, sold through confidential negotiations with one bidder—according to the target company’s choice.

Target companies have many representatives and agents that participate in the sale process. The board of directors (Board) has a fiduciary duty to maximize shareholder value and is responsible for organizing the sale process in a way that produces the best possible price. Boards often form special committees of independent (or disinterested, or nonemployee) directors to supervise the sale process and make sale-related decisions. This is done to avoid a conflict of interest (or an appearance of a conflict of interest) by employee directors who may be perceived to benefit from the sale through change-of-control payments (golden parachutes) or other arrangements including large equity stakes in the post-buyout firm.

The boards typically retain financial advisers—financial service companies knowledgeable in the target’s industry and mergers and acquisitions (M&A) markets—to help find the best acquirer, negotiate the terms of a deal, value the company and provide a fairness opinion (an opinion on whether the deal price is fair to shareholders from a financial point of view). They also retain legal advisers—law firms that help them structure deal agreements and explain the intricacies of compliance with their fiduciary duties. In some deals—especially if management or directors participate in the transaction—special committees retain separate financial and/or legal advisers.

The target company’s management often participates in the sale process, under the direction of its board. In some cases, top executives initiate the transaction and partner with investors to take the company private. These management-led deals are called management buyouts or MBOs. When the management of the company increases its equity holdings in the firm post buyout, care must be taken that the purchase price is fair. The structure of the sale process is therefore critical to ensure that any conflicts of interests do not influence the sale process.

Unless a public company has a majority or controlling shareholder with a large enough stake to make decisions individually, public shareholders have the right to vote on whether the company is sold at the proposed price. The vote happens in one of two ways: in a special meeting of shareholders where shareholders or their representatives gather at once, or through a tender, a process where each shareholder decides individually whether to sell his or her shares and communicates that decision to the acquirer’s representatives. In practice there is little difference between the two. In case of a shareholder meeting, the target typically engages a proxy solicitation firm that collects shareholder votes in advance of the meeting. Whatever the process, a private equity firm or a consortium cannot buy a public company without the consent of the holders of the majority of shareholder votes.

Although historically it was possible for a company to be acquired against the recommendation of its board through direct tender offer to shareholders (so-called hostile acquisitions), they have become very infrequent, and private equity firms have not followed this route for many years. According to Thomson Reuters SDC data, in the last 20 years only 77 hostile acquisitions of U.S. public companies were completed, and that number declined over time.⁶ None of these were acquired by financial sponsors, that is, private equity firms. The probability of success in hostile acquisitions is lower, and they can become very expensive because the boards can activate shareholder rights plans ("poison pill) whereby the company issues additional shares to existing shareholders excluding the hostile bidder. In addition, cooperation of the target’s management may be important for the post-acquisition performance of the target, and such cooperation may be difficult to secure in hostile deals. A higher acquisition cost and difficulties in the post-acquisition management of the target would undermine the expected return, which is of paramount importance to private equity acquirers. As a result, most private equity LBOs are friendly" deals.

Competition for LBOs and Corporate Control

Competition in contests for corporate control is comprised of a large universe of potential buyers. The largest share of acquisitions is done by strategic buyers, that is, other operating companies,⁷ as opposed to investment/financial firms such as private equity firms. If the target prefers to do an LBO with a private equity buyer, there are numerous private equity firms. An estimated 2,700 private equity firms operated in the United States in 2007.⁸ Among them, there are many large private equity firms.

Buyouts are also conducted by private operating companies (e.g., the buyout of Georgia-Pacific Corporation by privately owned Koch Industries in 2005) or wealthy individuals and families (e.g., the 2006 buyout of Cablevision Systems by its majority shareholders, the Dolan family). Hedge funds also have a presence in the buyout industry.⁹ Foreign private equity firms (like Permira) also compete for buyouts of U.S. companies, as do U.S. private equity firms for foreign buyouts.

The buyout firms themselves are different from each other. To ensure operational advantages, many private equity firms restrict their investment universe to a limited number of industries.¹⁰ Private equity firms differ in fund size and investment cycles, target returns/hurdle rates, access to credit, networks and relationships, and contractual requirements for their investments.

Private Equity Investors

Private equity firms do not invest just their own capital. They raise the majority of their funds from other investors in a series of private equity funds. Large private equity firms have multiple classes of funds; that is, they may have U.S., European and Asian funds as well as different types of funds, such as mezzanine, buyout, real estate and so on. Each private equity firm typically raises new funds every 3−5 years.¹¹ Most private equity funds are ‘closed-end’ vehicles in which investors commit to provide a certain amount of money to pay for investments in companies as well as management fees to the private equity firm.¹² Closed-end means that the fund is closed for additional investments and withdrawals by investors during its life. At any given time, one private equity firm may manage one or more private equity funds at different stages of their life cycles. A typical private equity fund is a limited partnership, with the private equity management firm serving as the general partner (GP), and investors as limited partners (LPs).

Limited partners are typically institutional investors—public (government) and corporate pension funds, insurance companies, college endowments and foundations, sovereign wealth funds (foreign governments)—and also wealthy individuals and families. One of the main drivers of private equity industry growth has been institutional investors’ portfolio allocation to private equity, which increased between 1997 and 2007 from 3 to 12 percent for large foundations and from 2 to 6 percent for endowments.¹³

The private equity funds are governed by contracts between GPs and LPs. Among other terms, these contracts typically have diversification requirements; that is, they specify the maximum percentage of the fund that can be invested in a single company or industry and sometimes the industries in which the fund can invest. Investments are limited in this way for prudential, or risk-management, reasons that are well expressed by the saying, do not put all your eggs into one basket. In practice, private equity firms diversify their investments even more than the contractual requirements.

Private equity firms’ fundraising comes in the form of commitments from LPs rather than actual cash. When an acquisition target has been located, a private equity firm calls on investors to contribute a proportional share of their commitments. This way there is no idle cash sitting in the fund waiting to be invested. In addition, private equity firms will call capital to meet the fees charged by the private equity fund managers.

Life Cycle of Investment

The purpose of a typical buyout is not to operate the target firm indefinitely but to own it for an intermediate period of time (e.g., six years)¹⁴ and exit by either reselling the firm to another buyer, selling its equity to the public through an initial public offering (IPO) or performing a leveraged recapitalization of the company. Private equity firms therefore make a commitment to work closely with consortium partners for several years to oversee and supervise the portfolio company.

Private equity firms look to invest when the company needs operational improvements and its stock price is depressed by market conditions, and to sell after the operational improvements have been made and market conditions become favorable. Private equity firms therefore do not profit just from the high leverage but also from their special skills in picking the targets, improving companies’ operations, governance and forecasting of industry cycles.¹⁵

Before purchasing a company, private equity firms conduct extensive due diligence—that is, research and analysis of the company’s strategy, business plans, financial information, products, relationships with customers, suppliers and employees, positioning in the industry and so on. The role of due diligence is to reduce information asymmetry between the target and the acquirer. This term describes a common situation where the seller knows a lot more about what it is selling than the buyer does. As a result, the buyer is afraid of a lemon and offers a low price. When a buyer gets access to better and more detailed information, information asymmetry is reduced, and the buyer can bid higher. Acquirers that are strongly aligned with the target’s management not only have access to the best information but are also able to interpret that information through the lens of key senior management.

In addition to being skilled themselves in analyzing targets and managing their portfolio companies, private equity firms typically retain leading consulting firms that have specific expertise in a particular industry or area of operations—both during the due-diligence period and after the purchase. Typical operating improvements that private equity firms introduce include retaining experienced professional management, reducing costs, spinning off noncore activities and achieving synergies with other portfolio companies of the same private equity firm.

A private equity fund typically exists for around 10 years (although LP agreements allow for extensions of typically three years)—during the first part of its life it invests the committed money, and during the latter part it returns it to investors.¹⁶ LP investments cannot be withdrawn in between and are therefore illiquid for up to 10 years. Private equity firms charge management fees to investors of private equity funds (typically 1–2 percent of committed capital), and in some cases to portfolio companies (deal fees will often be a percentage of the transaction value), but generate a major portion of compensation as carried interest (20−30 percent) on realized gains from investments.¹⁷

Valuation

An important step in a private equity firm’s investment is to value the target correctly at purchase. For a successful investment, the valuation has to be high enough for the target’s shareholders to sell, and provide for an attractive expected return.

Private equity firms as well as other market participants use different valuation methods, typically more than one method, to value each company. Financial economics teach that the value of a company equals the net present value of its projected future cash flows. In line with this, one of the popular valuation methods is the discounted cash flows (DCF) method. In this method the analyst forecasts future cash inflows (revenue) and outflows (expenses, taxes, investments) of a company and discounts them for the time value of money, accounting for the level of risk. Another popular method is to use valuation multiples from comparable transactions. In this method, the analyst collects a sample of other recent transactions similar to the one at issue and calculates, for example, the average ratio of price to some measure of earnings. This ratio can then be applied to the target company’s earnings. Finally, private equity investors will often do an LBO valuation model in which the investor models the internal rate of return on their investment assuming a certain equity investment at the onset and some exit in the future. Private equity investors will typically have a hurdle rate that their investments must meet, that is, the LBO model valuation must supply a rate of return above some specified hurdle rate.

Although these valuation methods are standard, there is significant variation in their application. In the DCF method, the analyst has to forecast the future cash flows of the company, which is inherently uncertain and requires a lot of assumptions. In the multiples method, the analyst has to choose which deals are similar (and no two companies are exactly alike), which multiples are most appropriate and so on.

As a result, no two analysts would necessarily arrive at the same valuation of a target, no matter how informed, analytically rigorous and educated their analyses. Market participants, therefore, place different value on the targets—different bidders are willing to pay different prices; the target’s management can have a different analysis of the sale price than its board’s financial adviser; and analysts, shareholder advocates and shareholder advisory services may have their different opinions. Information asymmetry between these players further exacerbates these differences.

Private equity firms typically utilize their own cost of capital to determine the value of a potential target. The firm will typically have a hurdle rate that it intends to achieve on its portfolio. This hurdle rate is typically communicated to limited partners as the target rate of return. Investments typically must have expected returns above this hurdle rate to justify investment.

Debt Financing

Private equity firms’ returns, in part, are due to high leverage. Debt financing in an LBO is typically a combination of bank loans (the majority), high-yield bonds/notes, mezzanine debt and asset-backed securities.¹⁸ LBO debt usually has no recourse to the private equity sponsor of the transaction—it is debt of the target company. Debt providers therefore conduct their own analysis of the target company. They evaluate the target’s cash flow (which has to be large and stable enough to service large debt), collateral (assets that could be sold when cash is insufficient to service debt) and management credibility. Private equity firms’ relationships with debt providers are important in the assessments of management because, after a deal, the private equity firm participates in the management of the company.

High leverage dramatically increases the risk of an equity investment. For example, with 20 percent equity and 80 percent debt financing, a 10 percent decline in the value of the portfolio company would result in a 50 percent loss of the equity investment. Private equity investors expect high returns commensurate with this high risk. Researchers’ estimates of private equity returns vary—some find high returns, others conclude that the realized returns to their investors are often much lower. For example, Kaplan and Schoar found that returns to private equity and venture capital fund investors’ earned net of fees were slightly less than the Standard & Poor’s 500 (S&P 500) index.¹⁹

A Brief History of the Private Equity Industry

During the 2003–7 period the private equity industry gradually expanded in terms of both deal volume and transaction size. Although estimates vary, in one estimate, total deal value increased almost 18-fold between 2003 and 2006, to $375 million in 2006.²⁰ In another estimate of the $3.6 trillion buyouts worldwide between 1970 and 2007, $2.7 trillion were undertaken after 2000.²¹

This growth was fueled by the increasing availability of both equity and debt to finance transactions at an attractive price. Debt became more available due to a combination of decreasing interest rates and the development of structured credit markets.²² Debt availability alone, however, is not sufficient to enable private equity industry growth. There is a limit on leverage in each particular deal. First, debt providers carefully evaluate transaction structure and cap the debt-to-equity ratio as a result. Moreover, part of the debt in each LBO is sold to the public or to a broader group of investors who rely on credit ratings to evaluate the risk of their investments. The credit rating is typically lower for higher leverage, and as a result investors demand a higher return in these transactions. With increasing leverage, debt can become too expensive.

Therefore, private equity firms could borrow only as much as their equity capital allowed. Private equity firms were able to gradually increase their fundraising, but the most dramatic expansion did not happen until late 2007. Annual funding commitments increased from $162 billion in 2005 and $215 billion in 2006 to $302 billion in 2007.²³

As a result, private equity firms were able to acquire larger companies. The figure above provides an overview of the expansion of private equity investments by deal range. While the number of deals at the lowest end of the size spectrum increased 40 percent between 2003 and 2007, the number of deals above $2.5 billion increased more than 14-fold, from 3 deals in 2003 to 44 in 2007.

Notes

1 A. Metrick and A. Yasuda, Venture Capital and Other Private Equity: A Survey, European Financial Management , 17(4), 2011, 619–54.

2 Sreedhar T. Bharath and Amy K. Dittmar, Why Do Firms Use Private Equity to Opt Out of Public Markets?, Review of Financial Studies , 23(5), 2010, 1771−818.

3 Bharath and Dittmar, Why Do Firms Use Private Equity to Opt Out of Public Markets? Information considerations include information asymmetry (discussed later) between public shareholders and management, inefficiency in the monitoring of the company by numerous shareholders and diverse information between shareholders. Agency considerations refer to alignment of manager incentives with those of shareholders.

4 Steven Davis, John Haltiwanger, Ron Jarmin, Josh Lerner and Javier Miranda, Private Equity and Employment, U.S. Census Bureau Center for Economic Studies Paper CES-WP-08-07, 2008; http://papers.ssrn.com/sol3/papers.cfm? abstract_id=1107175 . Josh Lerner, Morten Sorensen and Per Stromberg, Private Equity and Long Run Investment: The Case of Innovation, EFA 2009 Bergen Meetings Paper, 2008; http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1088543 . Frank R. Lichtenberg and Donald Siegel, The Effects of Leveraged Buyouts on Productivity and Related Aspects of Firm Behavior, Journal of Financial Economics , 27(1), 1990, 165–94.

5 Steven N. Kaplan and Per Strömberg, Leveraged Buyouts and Private Equity, NBER Working Paper 14207, July 2008.

6 The number of hostile acquisitions declined from 41 announced in 1992–96 to 22 announced in 1997–2001, 13 announced in 2002–6 and 1 announced between 2007 and the present.

7 For example, of 399 acquisitions of U.S. public companies valued over $2.5 billion announced between January 2003 and July 2007, only 56 were LBOs. Source: Thomson Reuters SDC database.

8 Sharon Tancredi, The Uneasy Crown—Private Equity, The Economist , February 8, 2007.

9 F. Partnoy and R. Thomas, Gap Filling, Hedge Funds, and Financial Innovation, Brookings-Nomura Papers on Financial Services, ed. Yasuki Fuchita and Robert E. Litan, Brookings Institution Press, 2007. (Although hedge funds today do not typically seek to take companies private, their capital structure-driven strategies resemble a kind of early-stage leveraged buyout.)

10 See, e.g., P. Cornelius, K. Juttman and R. de Veer, Industry Cycles and the Performance of Buyout Funds, Journal of Private Equity , 12(4), Fall 2009, 14–21. The authors find that 50 percent of private equity funds in their sample have portfolios that are highly concentrated (as measured by the Hirschman-Herfindahl Index, which is an index used by the Department of Justice and the Federal Trade Commission to measure industry concentration) and that large funds are as concentrated as smaller ones.

11 Metrick and Yasuda, Venture Capital and Other Private Equity: A Survey, 9.

12 See, e.g., Kaplan and Strömberg, Leveraged Buyouts and Private Equity.

13 Metrick and Yasuda, Venture Capital and Other Private Equity: A Survey, citing Cambridge Associates estimates.

14 Median holding period found by Kaplan and Strömberg is six years. Kaplan and Strömberg, Leveraged Buyouts and Private Equity. Strömberg finds that the median ownership of target companies by private equity firms is nine years. P. Strömberg, The New Demography of Private Equity, The Global Impact of Private Equity Report , 2008.

15 Cornelius, Juttman and de Veer, Industry Cycles and the Performance of Buyout Funds.

16 Metrick and Yasuda, Venture Capital and Other Private Equity: A Survey, 5.

17 A. Metrick and A. Yasuda, The Economics of Private Equity Funds, Review of Financial Studies , 23(6), 2010, 2303−41.

18 A. Shivdasani and Y. Wang, Did Structured Credit Fuel the LBO Boom?, Journal of Finance , 66(4), 2011, 1291–328, table 12. They report that [o]‌n average, bank loans comprise 53% of the LBO volume in their sample.

19 S. N. Kaplan and A. Schoar, Private Equity Returns: Persistence and Capital Flows, Journal of Finance , 60(4), 2005, 1791−823. The same result was obtained by L. Phalippou and O. Gottschalg, The Performance of Private Equity Funds, Review of Financial Studies , 22(4), 2009, 1747–76. In addition, Blackstone’s publicly traded stock underperformed the S&P 500 in the last five years and since the trading began.

20 Robert J. Samuelson, The Private Equity Boom, Washington Post , March 15, 2007.

21 P. Strömberg, The New Demography of Private Equity.

22 A. Ljungqvist, M. Richardson and D. Wolfenzon, The Investment Behavior of Buyout Funds: Theory and Evidence, NBER Working Paper 14180, July 2008, find that buyout funds accelerate their investment flows when credit market conditions loosen. Shivdasani and Wang, Did Structured Credit Fuel the LBO Boom?, show that LBO growth was at least in part caused by expansion of structured financing.

23 Kaplan and Strömberg, Leveraged Buyouts and Private Equity.

Private Equity Finance Vignettes: 2016¹

Paul A. Gompers and Victoria Ivashina

Founder’s Battle

In early July 2013, Isaac Scott, a senior director at the Brandon Hills Teachers Retirement Fund, convened his entire investment team to prepare for a shareholder meeting that would significantly impact his firm’s struggling investment portfolio.² Brandon Hills Teachers Retirement Fund was a large shareholder of Dell and in a few weeks, it needed to vote on the $24.4 Bn leveraged buyout deal that Silver Lake Partners had struck with Dell—the computer technology giant lately troubled by declining PC sales and the rapidly evolving ecosystem. If successful, the deal would be the largest leveraged buyout since the 2008 financial crisis as well as the largest technology buyout ever.³

The price of the deal was the primary point of discussion for Scott and his team. On the one hand, some of Dell’s largest shareholders emphatically opposed the deal because they felt that the price was too low. At $13.65 a share, this offer was a 25% discount to Dell’s recent high in February 2012 of $18.16 a share (see Exhibit 1). Furthermore, Southeastern Asset Management—the largest outside shareholder of Dell—contended that the offer undervalued the company by almost 75%. (See Exhibit 2 for Southeastern’s Dell valuation at $24 a share.)⁴ Carl Icahn, the billionaire hedge fund investor most famous for ruthless shareholder activism and his titanic battles against several large corporations, joined Southeastern in the fight against the buyout group led by Michael Dell, who founded Dell in his college dorm room in the late 1980s.

On the other hand, the price seemed to be a fair price for the struggling PC maker. Shareholders would receive $13.65 a share in cash, representing a 25% premium over Dell’s share price on January 11, 2013 which was when rumors of the buyout erupted. With tablets and smartphones constantly eating into Dell’s revenues, Silver Lake’s offer seemed to be a viable exit opportunity for many discouraged shareholders. In response to arguments regarding a conflict of interest for Michael Dell as both the buyer and the current CEO, the founder assured that Dell’s board was acting on the recommendation of a special committee of independent directors and that he recused himself from the discussions as well as the board vote.

In addition to price, many observers wondered whether a private equity-backed LBO could effectively turn Dell around. (See Exhibit 3 for proposed capital structure.) During the go-shop period, the Blackstone Group had made a considerably higher rival bid for Dell. However, it recently withdrew its offer after determining that Dell’s business was declining more quickly than expected. In a letter sent to the special committee of Dell’s board, Blackstone cited its reasons for withdrawal including an unprecedented 14% market decline in PC volume in the first quarter of 2013—its steepest drop in history and inconsistent with management’s projections for modest industry growth.⁵ Blackstone’s retraction left Carl Icahn as the only rival against Silver Lake and Michael Dell. Silver Lake, a $23 Bn private equity firm founded in 1999 to focus on technology investments, was confident that the new injection of capital would propel Dell to expand its focus on more profitable parts of the business such as cloud computing.

The Brandon Hills Teachers Retirement Fund was faced with three options for the imminent shareholder vote. One, it could vote to oppose all buyout proposals and have Dell stay the course as a publicly-traded company. Two, the fund could vote in favor of Michael Dell and Silver Lake’s buyout offer and walk away with $13.65 a share in cash. Three, the fund could side with Carl Icahn, who proposed to pay a special cash dividend of $12 a share and thereby allow shareholders to keep holding stock in the company. Scott looked through his notes and wondered what to do.

The New Opportunities for Limited Partners

In May 2015, Victor Alvarez, the head of a family office—which had about $600 million assets under management—was looking at an invitation to co-invest alongside a large private equity fund in a multi-billion-dollar buyout.⁶ The investment would happen in parallel with the general partner’s (GP’s) main buyout fund, but would stand as an independent vehicle. In bypassing the fund, co-investment would have no carry or management fees, and would only be subject to a 1% co-investment fee.

In recent years, such co-investment offers had become increasingly frequent, even for investors with relatively small private equity allocations. This was a result of a broader push by large limited partners (LPs) to lower costs of investing in private equity and to boost net returns. Although co-investments were used by GPs as a way to differentiate themselves and to strengthen relationships with key LPs even in the early 1990s, co-investment really started to pick up around 2005. This was partly due to the growth in LPs’ allocations to private equity. For example, in 2001, California Public Employees’ Retirement System (Calpers), the largest U.S. pension fund, allocated less than 1% of its portfolio to private equity. By 2005, Calpers’ allocation to private equity was over 5% of its assets. In 2014, 10.3% of Calpers’ roughly $300 billion in assets was allocated to private equity.⁷

The unravelling of the global financial system in 2008 shifted further bargaining power toward LPs. In 2009, the Institutional Limited Partners Association (ILPA) articulated a set of principles that sought to improve transparency and increase LPs’ rights while reducing manager fees. It is in this environment that co-investing programs—which offered a lower fee and carry structure while granting LPs greater control over investment choices⁸—became the norm. After 2009, large limited partners would customarily receive the right to co-invest on a discretionary basis alongside the main fund.

By 2014, it was estimated that about 5% of overall private equity investments by limited partners were done as co-investments.⁹ According to Preqin survey data, in 2014, 56% of investors in private equity funds intended to increase their commitments to co-investments.¹⁰

Victor knew that there were alternative ways for his firm to gain exposure to co-investments. The firm could invest in a fund-of-funds with an allocation to co-investments, or they could pursue adding a commitment to a co-investment fund with a single GP. Such approaches would be less risky, but would also have a lower reward profile. The economics of co-investment seemed very attractive. However, Victor was wary that the co-investment deals that were available to his firm were particularly risky. Victor’s team was not unfamiliar with the buyout target in question, which is why this deal caught his eye in first place. Yet, with his small team and limited time, they would have to leverage the GP’s due diligence to make the final decision.

As was usually the case, this was a take-it-or-leave-it offer and there was pressure to move fast. Victor pondered whether this deal was the right opportunity for his firm to jump on the co-investment trend.

Have It Your Way

Adam Schwartz, the Chief Investment Officer at Republic University,¹¹ was delighted to learn that Texas Pacific Group, a key player in the endowment’s portfolio, was set to exit one of its largest portfolio companies—Burger King. Although the exit would not be another blockbuster initial public offering, it would be a strategic sale with moderately high returns. This was a much needed update for Schwartz, who felt that the endowment’s performance in alternative assets was subpar. Then Schwartz noticed that the remaining stake in the company was being sold to 3G Capital—another private equity firm in the endowment’s portfolio.

Burger King was founded in 1953 and since then, the company cycled through numerous owners and introduced thirteen new chief executives in just twenty-five years. Burger King was first bought out by Pillsbury Company, whose inexperience with restaurant chains only lent itself to meager performance. Consequently, Pillsbury sold the company to Grand Metropolitan, which also found it difficult to turn the cash-starved chain around. Then in 2002, private equity joined the party.

A troika of private equity firms composed of TPG Capital, Bain Capital, and Goldman Sachs Capital Partners acquired Burger King for $1.5 Bn, 85% of which was financed through debt.¹² The new owners implemented various measures including several CEO replacements and rebranding to revitalize the company. Although the investment group did not meet its original plan of taking Burger King public within two years, Burger King filed its registration for an initial public offering in February of 2006.

Three months later, Burger King issued an initial public offering and raised $425 MM, making it the largest IPO of a US-based restaurant chain. Although many celebrated the remarkable IPO, some were concerned with the fact that nearly all the proceeds from the IPO were used to pay off the private equity firms. However, Burger King’s CEO defended the alarming payouts, maintaining that the private equity firms still retained a 76% stake in Burger King and thus aligned their incentives with the company.¹³ The stake eventually declined to 31%.

Four years later, TPG, Bain Capital, and Goldman Sachs cashed out at $3.3 Bn. Hoping to close the gap with industry frontrunner McDonald’s, 3G Capital purchased Burger King at $24 per share, marking a 46% premium to the company’s share price before the announcement. Similar to the previous owners, 3G Capital immediately began to compensate itself through fees and dividends.¹⁴

Howard Penney, a managing director at Hedgeye, commented that the new owner did not drive Burger King’s performance by improving the company’s business fundamentals, but by laying off many of its corporate employees and cutting expenses. He also noted that the series of private equity firms had taken out over $1 Bn from Burger King in fees and dividends—capital that could have been used to boost the company against its competitors. In contrast, Bill Ackman, a prominent hedge fund manager, explained that the partners at 3G Capital were the best operators around, bar none and that they were eager to modernize and expand Burger King. (See Exhibit 4 for Burger King’s historical share prices.)¹⁵

As a limited partner, Schwartz contemplated the value of one private equity firm selling a company to another. He was uneasy with the considerable transaction fees and monitoring fees, both of which were almost always incurred at the portfolio company level, involved in the process. He also questioned 3G Capital’s ability to add value to Burger King in ways that its private equity predecessors had not. As a significant portion of the endowment was allocated to private equity, Schwartz became increasingly worried.

Safeway

It was March 6, 2014 and Thomas Goldstein, portfolio manager at Barber Money Management Corporation¹⁶ (BMMC) had just heard the news of the agreement by Albertsons to buy Safeway. Albertsons and Safeway were two of the country’s largest grocery store chains. As a large shareholder of Safeway, Goldstein knew that he would have to vote on the agreed merger transaction. As he read through the terms of the deal in the merger proxy, he began to contemplate how BMMC should vote on the transaction.

What made the deal interesting was that the real bidder on the deal was Cerberus Capital Management, one of the largest private equity firms. Rumors had circled for some time that private equity firms like CVC Capital Partners and Leonard Green were considering bidding for some or all of Safeway’s stores. Cerberus had acquired Albertsons from Supervalu in 2013 in a transaction valued at $3.3 billion.¹⁷ The proposed transaction was valued by Cerberus at $40.63 per share which implied an enterprise value of $10.6 billion ($9.6 billion equity value and $1.3 billion in net debt) making it one of the largest post-financial crisis buyouts. The transaction would pay Safeway shareholders $32.50 in cash at closing, an additional estimated $3.44 in cash or Contingent Value Rights from the net after-tax sale of non-core assets, and an additional $3.98 in value from distributing shares of Blackhawk, a gift card leader in which Safeway owned 81%. In 2013, Safeway had sold 19% of Blackhawk for $230 million in an IPO on NASDAQ with the intention of spinning off the rest of its ownership at a later date.¹⁸ There would be an additional $0.71 per share tax savings related to the Blackhawk spinoff. The financing of the deal would include $7.6 billion in new debt.

The investment thesis seemed to make sense from Goldstein’s perspective. Albertsons operated more than 1,100 stores under the Albertsons, Acme, Jewel-Osco, and Shaw’s brands. By adding the 1,335 Safeway stores, the combined company would become the country’s second largest grocery retail chain after Kroger’s. Both companies had been under price pressure from low cost entrants like Wal-Mart. Analysts believed that a combined company would save money by consolidating distribution and purchasing functions. Safeway’s CEO, Robert Edwards, announced that Safeway would consider any additional bids for the next 21 days. Any topping bid, however, would trigger a $250 million break-up fee that would be paid to Cerberus.¹⁹

Goldstein looked through the valuation materials included in the merger proxy. Goldman Sachs had provided a fairness opinion to Safeway’s board of directors. (See Exhibit 5 for excerpts from the valuation discussion in the merger proxy.) Goldman Sachs had approached the valuation in a number of ways and Goldstein was trying to understand which of these valuation methods made sense for him to rely upon. Additionally, he wondered how Cerberus would approach the valuation exercise.

Exhibit 1 Historical Dell Share Prices, June 2007–June 2013

Source: Compiled by author from Bloomberg LP, accessed July 2013.

Exhibit 2 Southeastern Asset Management’s Valuation of Dell

Source: Southeastern Asset Management, Inc. via http://www.PRNewswire.com, accessed July 2013.

Exhibit 3 Proposed Dell LBO Capital Structure

Source: Adapted by author from Sagalov, David, Dell Leveraged Buyout Analysis, Leveraged Finance Research (January 2013), Jeffries & Company, Inc.

Exhibit 4 Historical Burger King Share Prices, May 2002–October 2010

Source: Compiled by author from Bloomberg LP, accessed July 2012.

Exhibit 5 Excerpts from Safeway DefA14A, Merger proxy filed on March 24, 2014

The following is a summary of the material financial analyses delivered by Goldman Sachs to the Board in connection with rendering the opinion described above. The following summary, however, does not purport to be a complete description of the financial analyses performed by Goldman Sachs, nor does the order of analyses described represent relative importance or weight given to those analyses by Goldman Sachs. …

Implied Premium and Multiples Analysis. Goldman Sachs calculated the premium represented by the aggregate of (i) the Initial Cash Merger Consideration of $32.50 per share of Company common stock, (ii) the Assumed CVR Cash Proceeds of $3.44 per share, (iii) the value attributable to Safeway’s pro-rata ownership of the shares of Blackhawk Class B common stock distributed in the Blackhawk Distribution of $3.98 per share, which was based on the $24.78 per share closing price of Blackhawk Class A common stock on February 28, 2014, and (iv) the present value of Safeway’s pro-rata share of the tax savings to Blackhawk from the tax basis step-up related to the Blackhawk Distribution of $0.71 per share, which was based on the tax deductions to Blackhawk over time (referred to as Safeway WholeCo), or a combined $40.63 per share of Company common stock. …

The results of these analyses are summarized as follows:

By multiplying the equity value of Safeway WholeCo, or $40.63 per share, by the total number of fully diluted outstanding shares of Company common stock calculated using the treasury method, Goldman Sachs derived an implied equity value of Safeway WholeCo of approximately $9.6 billion. Goldman Sachs then added to this implied equity value Safeway’s total adjusted net debt balance of $1.3 billion and derived an implied enterprise value of Safeway WholeCo of approximately $10.9 billion.

Using the results of the calculations described above, Safeway WholeCo’s actual financial results for the 52 weeks ended December 28, 2013 (FY 2013) reflected in Safeway’s publicly filed financial statements, the Projections for the 53-weeks ending January 3, 2015 (FY 2014E) and the 52-weeks ending January 2, 2016 (FY 2015E) and selected estimates for Safeway WholeCo’s FY 2014E and FY 2015E financial results published