ISSUES IN PRIVATE EQUITY FUNDS

ISSUES IN PRIVATE EQUITY FUNDS

TERESA BARGERPRIVATE EQUITY AND INVESTMENT FUNDSINTERNATIONAL FINANCE CORPORATION

2

What is a Private Equity Fund?What is a Private Equity Fund?

♦ Up-front commitment of capital for future investments.

♦ Collective investment vehicle♦ Defined life (10 years is standard; IFC likes shorter)♦ Professional fund manager / GP♦ Management fees to cover costs (2% is standard)♦ Incentive for manager:

Carried interest(usually 20% after a hurdle rate of 6 – 10%)

3

Capital Base OvertimeCapital Base Overtime

00 44 55 1010

$$

Commitment Period

Divestment Period

-- - - Committed amount

______ Invested amount

4

Fee: Commitments

44 1010

100100

6060

2% of committed capital

2% of invested capital

outstanding

5

Fees Fall Over TimeFees Fall Over Time

00 1010

Fees

$Fees

$

6

How Can Manager Keep Teams Together?

How Can Manager Keep Teams Together?

00 1010

Fees

$Fees

$

2020 3030

Fund 1 Fund 2 Fund 3

Only teams with a good track record can raise follow-on funds

Only teams with a good track record can raise follow-on funds

7

In the Go-Go days, the half life of US -Venture Capital Funds was short.

In the Emerging Markets, it is longer.

In the Go-Go days, the half life of US -Venture Capital Funds was short.

In the Emerging Markets, it is longer.

00 1010

EM P.E.

U.S. V.C.

8

J CurveCash on Cash Patterns

J CurveCash on Cash Patterns

00 55 1010

00

IRRs typically do not turn positive until there are realizations and distributions.

IRRs typically do not turn positive until there are realizations and distributions.

9J Curve

Cash on Cash PatternsJ Curve

Cash on Cash Patterns

00 55 1010

00

FMV

For valuations, IFC needs to look at the Fair Market Valueat any point in time.

For valuations, IFC needs to look at the Fair Market Valueat any point in time.

10

What is difference between Venture Capital

and Private Equity?

What is difference between Venture Capital

and Private Equity?

Seed Early Stage

Development Capital

Buy Out Pre -IPO IPO / Strategic

Sale

VC

PE

11

What is the Investment Thesis?What is the Investment Thesis?

Private Equity: making the world safe forstrategic investors.

Individual / Family

Financial InvestorsØ Adds valueØ ProfessionalizesØ May change ManagementØ May mergeØ Seeks to build a company

with large market share, valuable products, customer franchise, etc.

Strategic InvestorØ Main take-out

route for the financial investor

(IPOs are rare)

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Investment ThesisVenture Capital

Investment ThesisVenture Capital

Idea / Seed Friends, Family &

Fools (angels)

Later Rounds of Financing

Sale / IPO

Ø High growth.

Ø Exceptional product / Intellectual Property

Ø Need weekly & monthlyboard meetings; close monitoring

13Generic Private Equity Deal Types(typical deals are a blend of several of these)

Generic Private Equity Deal Types(typical deals are a blend of several of these)

Company reaches a size at which it is a viable IPO candidate or attractive M&A target; or high expectations of future profit growth are built into pricing..

Earnings of company attract a higher price.

Multiple expansion due to growth or profits.

Company attracts more buyers as it is easier to understand and buyers have more protection. Do via improved accounting and reporting standards and greater minority rights.

Earnings attract a higher price.Improved transparency and governance

Requires quality corporate management and flexibility of labor and capital.

Increased profits via improved efficiency or shifting product into higher-margin niche.

Margin Expansion

Requires quality corporate management and stable/growing economy.

Increase earnings through expansion or acquisition.

Earnings growth

Requires a stable environment, low real interest rates and access to debt.

Leverage a company with stable earnings.

Leverage

Simple arbitrage is rare in EMs due to inefficient markets. Investment banks best positioned to spot it.

Pricing multiple differential between private market and public/M&A markets.

Arbitrage

DiscussionSource of profitType

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Growth, or high expectations of growth, create exits. Simple concepts are backable in large economies as they can grow to listed company scale, while the same concept in a smaller economy will plateau at family company size.

Is there enough growth potential to create an exit?Growth

Exits are easier for companies large enough to list; larger companies with attractive market share; companies with high expected profit growth. Minority stakes in unlisted companies are very difficult to sell. Drag-along and tag-along rights are useful but need to be enforceable.

Can you buy things that you can re-sell?Exit

Private equity relies on control in order to make required operating changes and strategic decisions.

Is it possible to obtain control through either majority positions or shareholder agreements?

Control

DiscussionBasic question

Building Blocks of Private Equity (I)Deal Flow

Building Blocks of Private Equity (I)Deal Flow

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Good management is key to any strategy relying on growth or margin expansion. US GPs have stables of on-call managers. In emerging markets quality management is at a premium.

Can you get good management to implement your strategy?

Managerial talent

Lack of debt finance has a negative impact on private equity returns.Lack of flexibility in structuring may hinder debt-based strategies to exit and structure risk.

Is both term debt and working capital available? Are different classes and structures of capital recognized?

Financial structuring

Capital controls?Tax?Foreign purchase of assets?

Regulation

Are accounts transparent and reliable?Are relationships with suppliers and buyers arms-length?

Can you really understand what is going on?

Transparency

In many countries title to land and other property is not clear. You improve a company – and then someone claims it as theirs!Poor contract enforceability undermines private equity.

Will the buyer be secure in ownership? Is ownership clear and easily transferred? Enforceable?

Property rights

DiscussionBasic question

Building Blocks of Private Equity (II)Building Blocks of Private Equity (II)

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Impact of possible emerging market constraints: IRR & cash multiple before fees. Illustrative only.

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

Developedmarket

Longer toexit

Lessleverage

Highernominalinterest

Lessmultiple

expansion

Moreearningsneeded tofinanceworkingcapital

Slowerearningsgrowth

Devaluation

IRR

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

cash

mu

ltip

le

IRR

Cash multiple

17

“Persistency”“Persistency”In private equity, the spread between top performers and average performers is large.

If you are not with a top fund manager, you would do better investing in bonds.

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“Persistency”- Success in Private Equity is not Luck, it is Skill.

“Persistency”- Success in Private Equity is not Luck, it is Skill.

Mc Kinsey finding in Europe:

“If your first fund was top quartile, there is a 45% chance your next fund will also be top 25% and a 73% chance it will be top half. A new fund management team has a 16% chance of being in the top quartile.

Success in private equity is persistent.”

Conor Kehoe, Partner McKinsey & Co., EVCA, June 13, 2001

19Matching the Business Plan & the GP (example)Matching the Business Plan & the GP (example)

Yes

General concept:‘need for restructuring’

Do sellers faceenough pressure

to accept dilution?

Are the rights of different tiers of

capital clearly defined?

Can shareholder agreements be enforced?

Are there exits for the type of deal available?

No

Deal Flow?

No

Deal Flow?

NoSTOP unless can buy majorities

NoSTOP

Are management talent, leverage & other factors

required to extract Value available?

Access to deal flow?

Relevant previous experience?

Track record?

Understand localconditions: legal,

family connections?

Ability to negotiate &structure locally?

Ability to source debt,management & other factors necessary to

extract value?

Ability to identify exits?

No

No

No

No

No

No

STOP

STOP

STOP

STOP

STOP

STOP

YesGO!GO!

No

Can GPFind it?

NoSTOP

20

Investment ProcessFor venture capital, can take 2-6 weeks from deal alert.

Investment ProcessFor venture capital, can take 2-6 weeks from deal alert.

Create awareness of PE

Get Deal Flow

1st. Screen for deals

Deal Alert Preliminary or actual due diligence

Formal write up for decision

Investment Committee

Ø Contacts

Ø I Banks &

accountants

Ø Own network

Ø Seminars

Ø Cold Calling

ØMust fit

objectives

Ø Feel for

economies

1 page write up to inform colleagues

Can be all internal or internal & external

Final diligence and documentation

I.C. sign off if necessary

Final Documents

Closing

Value Addition and DivestmentTHEN

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Gross Fees

Cash Mgmt

29 % 3% Management

Fee

Ø Auditing

Ø Board

Ø Broken

Deal

Ø Capital calls in advance

Ø Capital returns on a schedule

Ø Keep dividends

u Need J.I.T

Net

9 %

Net & Gross IRR Net & Gross IRR

Expenses

Fees paid to fund by investees

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We need managers who are hungry for NET IRR !

We need managers who are hungry for NET IRR !

Ø Should eat sandwiches on fees and caviar on carry

Ø Should be possibility of reaching carry.Ø To increase net:

* Invest 120 % of fund (reinvestment w/o fees)

* J.I.T. (Just-in-Time) cash management insteadof J.I.C. (Just-in-Case)

* Get fees from portfolio companies

23

Try Not to Pay “Fee – on – Fee”Try Not to Pay “Fee – on – Fee”

00 1010 1212

2 %

Committed & Outstanding

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“Fee-on-Fee”: Solutions?1. Make 2 commitments:

a. $100 for capitalb. $ 14 for fees and expenses…but still need IRR on $114 base.

2. After investment period, accrue fee but paid from investment returns…but still paying fee-on-fee in early years.

3. Allow re-investments without fee, with carry…but only want best managers to do this.

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Carry WaterfallA. Deal-by-deal (not common in developed markets, but

found often in emerging markets)B. Aggregate or full payout (to be encouraged!)

1. Partners get all capital & fees + expenses2. Partners get 8% compound p.a. (hurdle rate or preferred return)3. Catch-up on the hurdle goes to fund managers

X= 20% (preferred + X) or 25 % of preferred return4. Then 80 % to LP and 20 % to GP

If deal–by–deal, need clawback and escrow

26Main Terms & ConditionsMain Terms & Conditions

- What if market goes bad?- What % vote

Termination Clause- No fault divorce (in partnership)- Forced Liquidation- No fault suspension (freeze)

Specific but not too narrowInvestment Objective

Generally prefer partnership, tax drivenPartnership or Corporate Structure

Like at least 1% or meaningful personal amountGP Commitment

- Minimum size or no go- Maximum size if market is limited

Size of Fund

- approve annually (eg: 1+1, not 2)- fee should be reduced or zero- Need to emphasize to managers need for quick exits

Extension of Life

Trade off between better IRR and sufficient time to invest and divest

Life of Fund (8, 10 years)

REMARKSTERM

Continue

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Represses IRR if not just-in-timeDrawdown based on just-in-time

Can be difficult to match fund’s timingCo-investment policy- With carry

- Without carry

Creates problems that need to be dealt with upfrontOpt-out

Also use IFC exclusion listInvestment policy and limitations- Max % of fund in 1 company- Max % of fund in 1 country (if the fund’s

focus is regional)- Related companies- Size of investment

Avoids misaligned incentives of deal–by-dealAggregate carry

- Budget based fees- Manager should focus on carry

Fees, carry, and hurdle

-Continue the fund but replace the manager- Higher % vote required for firing without cause- Vesting schedule for carry

Firing the manager- for cause- without cause

REMARKSTERM

Continue

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Quarterly, per EVCA & IFC guidelinesReporting

Not until % of first fund is invested (eg: 80%)Follow–on investment funds by same manager

LPs should have right to transferTransfers

Can suspend new investments until replacement foundKey man clause

Does LP want the liability?Investment Committee

Require conflicts committee of outsidersMay need audit or valuation committee

Advisory Board or Board of Directors and Committees

Put a cap on itOrganizational expenses

Depends on confidence in GPRe-investments

Send all money back in 5 daysDistributions: immediate

REMARKSTERM

Thank you!Thank you!