P RIVATE EQUITY

In this part of the thesis we will focus on period after the transaction and main player in it – private equity firms. Private equity firms assume two roles in LBOs; which are the one of the buyer and / or the one of the provider of finance. Below we will attempt to describe both roles as thoroughly as possible given our experience and access to information.

Private equity firms operate through funds which are their investment vehicles. These funds are basically pools of capital compiled from entries of private equity firm and various institutional investors. They are organized as limited partnerships although other legal structures are used as well²⁵. Private equity firm fulfills role of general partner and controls operations of the fund.

Limited partners committing their capital to funds are mostly institutional investors but also individuals of substantial wealth. They become passive partners as funds provided

25 Kaplan and Schoar (2003)

by them are managed by general partner (private equity firm). Institutional investors are represented by insurance companies, pension funds, financial institutions, universities’ trusts etc. Limitations on investments into private equity funds make it virtually impossible for commoner to invest into such funds. Initial investments are almost always in excess of USD 100ths and further investments (“drawdown”) are required²⁶. Other drawbacks include illiquidity of the investments and high risk of losing all money if invested into failing companies.

Illiquidity is caused by the legal form of funds which is limited partnership and nature of the business. Limited partner shares is considered as equity of the company and therefore it is last to be settled in case of liquidation. Also to the contrary of stocks and bonds, limited partner share has no market to be traded on and thus it is very rare to sell the investors share. Distribution are made only upon cashing the investments from the portfolio of the fund when there are sold which is done after several years. General partners have several years (e.g. 5) to invest fund’s capital and another period (e.g. 7 years) to improve performance of portfolio companies and resale them. Overall fund life cycle can last up to 12 years. If the fund was successful and investors are pleased with their returns, follow up fund can be created.

Not every fund is successful and investors can easily lose lot of money as investments are chosen not wisely. Risk is lower then risk venture capital investors are facing as investments are made into established and running companies. Venture capital invests into start-up companies in which bright future venture capitalists believe. On the other hand risk of private equity funds investors is higher then the one facing investors into mezzanine funds. These funds offer mezzanine financing to the companies and as this is debt financing (although subordinated) it is less risky than any of equity investment.

General partners make all decision regarding investments and their subsequent management. For these activities he charges annual management fee which is 1.5-2.5 percent of committed capital and approximately 20 percent of carried interest or share of the profit²⁷. 20 percent charge kicks in only if hurdle rate is achieved (meaning target rate of return of the fund). Repeatedly successful funds are able to charge fees even in excess of those stated above. Considering use of leverage funds are able to

26 www.wikipedia.org

27 Kaplan and Schoar (2003)

outperform all major stock indexes. Besides management fee and charge from the profits we should not forget fees private equity firms are charging to their portfolio companies for provision of various advisory and management services. Also fund managing people are put in charge of acquired companies and further add to their already substantial income. Only occasionally companies higher external advisors or management and in this case they have to usually pay even more as these external managers are retired chief executive officers of with deep industry experience. Cheaper option is to involve present management and try to motivate them (usually through stocks options plans) to stay and work for the company also after acquisition.

Mezzanine financing

Mezzanine finance become in 21^st century one of the alternative investment techniques for private equity firms, specifically European private equity funds. More and more of them dedicate some of their funds to mezzanine financing of middle market firms (with revenues of up to USD 500m²⁸), because this is new area of focus and can eventually lead to ownership share in target. As mentioned in first part of the chapter, it fills gap between senior debt (loose covenant characteristics and higher ratios) and equity.

Companies, too small for public debt issue and too big or with no more funds available via traditional forms of borrowing, seek it in order to finance their (i) acquisitions, (ii) CAPEX and (iii) recapitalizations. Although it is used to finance business growth it is by no means business plan financing.

Use of mezzanine finance enables basic advantage of leverage financing as acquirer does not need cash and capital in whole amount of purchase price. For example if purchase price was USD 200m and bank was only willing to lend up to USD 100m, acquirer would have to have capital of USD 100m. But if he is able to rise mezzanine debt in amount of USD 50m, then even though bank is unwilling to lend more than USD 75m due to higher risk, he has to have capital only of USD 75m (USD 200m – USD 50m – USD 75m).

Increased popularity should be at least partially contributed to ability of mezzanine debt to bring cash to lender not only after several years but almost immediately (due to cash coupons). Unwanted J-curve effect of yields of private equity funds is thus diminished or totally eliminated. Interest payments are made partly in cash and partly in form of

28 Bank of America (2003)

pay-in-kind. In Europe interest rates are negotiated as floating while in US on fixed rate basis. Internal rate of return (“IRR”) expected by investor is anywhere within 15-25 percent but strong competition in last years and introduction of new techniques and options to finance companies, pushed IRR expectations into low teens²⁹. Typical volume issued is up to USD 50m but can occasionally exceed USD 150m - development more common in Europe as over the years mezzanine finance become direct competitor of HY bonds.

To add further to differences in Europe and US mezzanine issues we should mention that European debt is issued as secured (occasionally in form of Collateralized Debt Obligation – “CDO”) while in US only rarely. Assets used as collateral are same as assets used for senior bank loans but of second rank. Also please note that while in Europe become quite popular warrant-less issues of mezzanine debt, in US warrants are still important feature. Co-investment is made via cash contribution or with set exercise price. In order to protect steady stream of high interest payments and decrease possibility of refinancing, call protection clauses (for first 3 years) together with steep penalties for early repayment are placed into contracts.

In 1980s mezzanine debt was domain of insurance companies, savings and loans association. At the beginning of 1990s first limited partnership firms and thus specialized funds appeared and mushroomed by the end of the century. Today we can safely say that in mezzanine financing are involved virtually all kinds of financial investors, from private equity firms, hedge and pension funds to investment banks, and other institutional investors mentioned already. It appeared in times of credit crunch when banks put ceilings on commercial lending to the companies and they had to seek alternative ways. Up to date mezzanine capital fulfills role of anti-cyclical provider of finance to companies³⁰.

Mezzanine finance is due to its nature (costly and used for acquisition purposes mostly) refinanced or eliminated from the balance sheet as soon as possible. Refinancing is done usually during change of control, recapitalization of the company or simple substitution with cheaper alternative (HY bonds which does not require security etc.).

IPOs are not common at middle market and therefore it is rather rare option.

29 Bank of America (2006a)

30 Bank of America (2002) and (2006b)

Adding value

Although mezzanine financing is enticing option, private equity firms through their funds are much more focused on purchasing the companies and increasing their value in order to achieve mind boggling returns on capital invested. There are four basic ways to increase value of the company which will be discussed further on³¹:

i. Selling high when buying low (value arbitrage or multiple expansion) ii. Restructuring balance sheet

iii. Restructuring profit and loss statement

iv. Adding value through growing the company extensively

Value arbitrage is the simplest “creation” of value by private equity firm. It requires little or no input by private equity house as it concentrates on misevaluation of the market and macroeconomic development. Taking away past years corporate scandals of recent past, there were always companies which were either ignored by analysts or improperly advertised to potential investors by their management (either due to negligence or their inability to do so). On the other hand buyout funds know exactly how to communicate and follow niches of the market and thus extract maximum value from its investments (either by sale to strategic investor or IPO). Perfect example of such is Pegas, a.s. IPO in December 2006. Although second largest producer of non-woven textiles in Europe it was little known among public prior to its IPO.

Particular sectors are also affected by macroeconomic development and cyclical nature of supply commodity prices (e.g. oil and coal prices). If company is caught in such draught it is easy prey for private equity house and its buyout fund. All what is needed to be done for private equity is to sit out the downturn and eventually help management with adjustments regarding financing. After the downturn pasts relaunch company on stock exchange is ideal way to exit as investors jump on a bandwagon. Success of financial investors dwells in ability to find such opportunities and identify suitable companies for taking private or buyout.

Another way to increase value of company through value arbitrage is to ride wave of expansion of major corporations which periodically expand and contract their range of products, divisions and shed or acquire non core assets. Buyout funds are ready to acquire unwanted divisions and resale them when new way of conglomerates is

31 Blaydon and Wainwright (29 September 2006)

coming. In between several secondary buyouts can happen as funds are not willing to wait for it.

By using auction process and multiple bilateral negotiations³² private equity increases competition on its exit and thus virtually assures itself premium over market valuation.

Auction processes are enabled only due to awareness of buyers / investors about ability of buyout funds to find targets with anticipated value increase.

Balance sheet restructuring is based on notion that companies with significant assets and steady cash flows can be leveraged significantly (by using assets as collateral and cash flows for debt service). Even more interest paid was usually tax deductible and thus created tax shields added value to the company³³. Of course danger of overleveraging company and thus increasing risk above bearable level puts limits on debt financing and eliminates tax shields effect with increased cost of equity and debt.

Besides restructuring balance sheet from long-term perspective (debt and equity), private equity increases cash flows towards investors by squeezing balance sheet on short-term basis. This is done via working capital restructuring. By decreasing length of working capital cycle (see Graph 4) buyout funds can extract additional cash used for debt service.

via; (i) renegotiating payment terms with customers, (ii) improving invoicing discipline (e.g. by issuing invoices promptly), (iii) improving collection of receivables (e.g.

sending reminders), (iv) outsourcing receivables and sales ledger (e.g. factoring) etc.

32 Blaydon and Wainwright (29 September 2006)

33 Using valuation techniques that value company as equity financed only plus tax shields created by adding debt to the capital structure, as in Blaydon and Wainwright (29 September 2006)

Inventory days ( days

introduction of inventory management software, (ii) eliminating of obsolescence stock, (iii) simplifying products by reducing variety of parts needed, (iv) optimizing production process flow etc. As inventories are usually in form of raw materials, work-in-progress and finished goods, attention to each kind of inventory should be paid in payments of invoices, (iii) entering into partnerships with key suppliers etc.

Private equity funds are especially focused on working capital management of the companies and trends in it in order to understand her operations and cash level necessary for smooth operating of company as well as estimation of amount of debt that can be used in transactions and refinanced by target’s cash flows.

Profit and loss statement restructuring is the most common tool used by private equity houses for increasing value of company. There are three basic ways to do that; h i. Decrease costs of making products either by increasing material usage

efficiency or work force effectiveness.

ii. Reduce the costs of overheads (cost of operating the company), but this can backfire as management is not motivated to scale back their power and remuneration packages.

iii. Sales profitability increases (e.g. by price increase).

Cost cutting often affects research and development department, CAPEX, remuneration packages (by switching to performance based schemes) and selling non core assets.

These actions are not very popular between other stakeholders in the company and could trigger actions and negative perception. Even though increasing financial health of the company private equity funds are often viewed as barbarians³⁴.

Growth LBOs emerged only in second half of 1990s as globalization progressed significantly and new emerging markets opened up to capital inflows. Private equity in this period turned its focus on targets with well established products or services on

34 Burrough and Helyar (2004)

domestic / local markets. Without need of restructuring or recapitalizing they were ready for next step and to go international. Introducing products to new markets and increasing product range became alpha and omega of private equity held companies.

Cash generated by the company is used for expansion and management is remunerated based upon its success. With increased size come bulk discounts from suppliers and further improvements in cash generation. On the other hand going global is a risky business as markets differentiate substantially on cultural and economic levels. As owners depend on management of the company, and private equity funds with its portfolio consisting of many companies in particular, management is today scrutinized extensively and replaced immediately in case of failure.