Financial Mgmt Assignment 2 - Private Equity

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Assignment 2

Private Equity

Presented by:

Bayer, Stefanie

Cavaleri, Tobias

Díaz Palancar, Alfredo

Stoll, Jürgen

Stolz, Oliver

Lecturer: Dirk Zimmermann

Class: Financial Management

MBA GM06 (Spring 2010)

Due Date: 21.06.2010



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Financial Management Private Equity

Table of Contents

Index of Figures ............................................................................................................... iii Index of Tables ................................................................................................................. iii Index of Abbreviations ..................................................................................................... iv 1 Introduction and key definitions ................................................................................ 1

1.1 What is Private Equity? ...................................................................................... 1 1.2 Private Equity Firms ........................................................................................... 2 1.3 Private Equity Funds .......................................................................................... 3

2 Market size and major trends 2010 ............................................................................ 5 3 Types of Private Equity transactions ......................................................................... 9

3.1 Venture Capital ................................................................................................. 10 3.2 Growth (Expansion) Capital ............................................................................. 12 3.3 Acquisition / Buyout financing transactions .................................................... 12 3.4 Other types of transactions ............................................................................... 14

3.4.1 Secondary buyouts .................................................................................... 15 3.4.2 Mezzanine Financing ................................................................................ 15

4 A typical MBO process............................................................................................ 16 5 Private equity as a financing source ........................................................................ 19

5.1 Key findings on Productivity and Management performance .......................... 20 5.2 Key findings on Strategic Portfolio and continuity .......................................... 21 5.3 Key findings on employment ........................................................................... 21 5.4 Summary of Pros and Cons on the PE as financing activity: ........................... 23

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



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Index of Figures

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

Deutscher Kapitalbeteiligungsgesellschafen)) .................................................................. 2 Figure 2: Private Equity Fund Diagram (How do Private Equity Fund Investments

Work? 2010)...................................................................................................................... 4 Figure 3: Global LBO volume in US$billion by Region, January thru June 2009

(RREEF Research 2009) ................................................................................................... 5 Figure 4: Growth of primary and secondary PE market (RREEF Research 2009) .......... 7 Figure 5: Product Life Cycle (Fraser-Sampson 2010, 8) .................................................. 9 Figure 6: The MBO-Participants and their roles (own illustration based on (Manches

LLP)) ............................................................................................................................... 17 Figure 7: Organizational and financial flow of a MBA-process (own illustration based

on (Manches LLP) and (Hoffmann et al. 1992, 68))....................................................... 18 Figure 8: Private equity-owned firms have the best raw management practice scores on

average (The Global Economic Impact of Private Equity Report 2009, 11) .................. 20 Figure 9: Manufacturing employment under private equity targets: year and as

percentage of manufacturing sector employment (The Global Economic Impact of

Private Equity Report 2009, 39)...................................................................................... 22 Figure 10: Private Equity Landscape Chart (Tuck Center for Private Equity and

Entrepreneurship) ............................................................................................................ 28

Index of Tables

Table 1: Real GDP chance (RREEF Research 2009) ....................................................... 5 Table 2: Future trends within private equity (own illustration) ........................................ 8 Table 3: Comparison of the three main types of Private Equity transactions (own

illustration) ...................................................................................................................... 10 Table 4: Pros and cons of PE as an alternative financing source (own illustration) ....... 23



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Index of Abbreviations

APAC

Asia-Pacfic

BRIC

Brasil, Russia, India, China

GP

General Partner

LBO

Leveraged Buyout

LP

Limited Partner

MBI

Management Buyin

MBO

Management Buyout

PE

Private Equity

SBIC

Small Business Investment Companies

VC

Venture Capital

WEF

World Economic Forum



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1 Introduction and key definitions

1.1 What is Private Equity?

“Private equity is money invested in companies that are not publicly traded on a stock

exchange or invested as part of buyouts of publicly traded companies in order to make

them private companies.” (Investopedia)

In general there are two different options to invest in a company.

If the company has gone public you can buy shares of that firm at the public capital

market (stock exchange market). This kind of investment is called “Public Equity”.

An investment in a company that is not listed at the public capital market is a “Private

Equity” investment. So the term “private” is related to the kind of the existing

ownership of the company’s equity. It doesn’t mean that the financing of the investment

itself is done by “private” money or cash.

There are some significant differences between the main characteristics of a “Public

Equity” and a “Private Equity” business.

In the form of Public Equity the investor has usually no limitation of the time frame of

his investment. He can handle his investments very flexible, which means adjusting his

business quite easy in a short term e.g. by buying and selling shares on a day to day

basis. Also it is a standard to put investments into different companies or industries. But

with this way of investment the investor does not have a big influence and power on the

company’s daily business and further strategic planning. A public company works like a

representative democracy. The designated board of directors monitors and discusses

with the Management the company’s future and development. The annual meeting is

more or less the only way to address an investor’s opinion to the board of directors.

In comparison the Private Equity investment is directly linked to a more entrepreneurial

attitude. With such an investment you can be part of the company’s management, if you

are have operational control, and you can play a part in decisions concerning the future

of the company’s business. On the other hand this kind of investment is less flexible to

rearrange or sell within a short time period. Only if the complete company value hasincreased it makes sense for the investor to sell his investment.



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

1.2 Private Equity Firms

Especially start-up companies need to raise money for finance growth. Very often the

business plans and strategies do not give opportunities to make profit in the short terms

which stops banks from giving out necessary loans.

Also Private equity firms very often invest in troubled companies. Of course they have

to analyze the financial structure and potential of profits carefully upfront to determine

if the profit risk ratio makes the investment reasonable. Therefore Private Equity

companies are an important tool for driving growth and improving performance for

companies that struggle to survive.

That can work out, because Private equity owners and the managers of their acquired

companies can focus in an accurate way on what is required to improve long-term

performance. This structure also makes it far easier to align the interests of owners with

those of managers who also have a direct stake in the success of the company.

“Private equity firms typically hold companies for about five years, and then sell them,

hoping to realize a gain on the sale as a result of the increased value they have createdduring their period of ownership. The general partners cannot recover any of their



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money until and unless they return to investors their principal plus the first eight to 10

percent of partnership profits. If there are no profits, PE partners not only make no

money, they lose their own equity investment.” (Private Equity Council 2008)

The most important Private Equity Companies worldwide today:

• Apax Partners (www.apax.com)

• Apollo Global Management LLC

• Bain Capital Partners (www.baincapital.com)

• The Blackstone Group (www.blackstone.com)

• The Carlyle Group (www.carlyle.com)

• Hellman & Friedman LLC (www.hf.com)

• Kohlberg Kravis Roberts & Co. (www.kkr.com)

• Madison Dearborn Partners (www.mdcp.com)

• Permira (www.permira.com)

• Providence Equity Partners (www.provequity.com)

• Silver Lake (www.silverlake.com)

• TPG Capital (www.tpg.com)

1.3 Private Equity Funds

Private Equity investing can be divided into two main categories: fund investing and

company investing. A Private Equity fund is a portfolio of companies established by a

Private Equity firm where interested parties can invest in. It is one layer above company

investment and for this reason company investment is also called direct investment.

Private Equity firms establish funds that raise capital from investors, who are known as

limited partners (LP). The Private Equity firm (called: general partner = GP) finally

decides to invest this raised capital along with their own capital into companies that

they believe can achieve profitability with their infusion of skill and capital.

Because one fund is grouping different investments from different kind of investors, PE

fund are also called as “pooled investment vehicle”.

Private equity funds are typically limited partnerships with a fixed term of 10 years

(often with annual extensions).



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The Private Equity firm is the expert to manage and control each issued Private Equity

fund. Also it is there key competence to establish a certain reasonable and balanced

portfolio of different funds across certain industries that fit to their particular focus of

business.

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

The Private Equity target is to create value over the long-term, compared to e.g. hedge

funds. Private equity funds typically own and buy whole companies and help them to

realize profit growth over time. Typically Private Equity firms own companies in their

portfolios for about five years.



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2 Market size and major trends 2010

In the past few decades, the private equity (PE) industry has grown both in terms of size

and geographic reach. In fact, PE has evolved into a major force in global finance over

the last 10 years. Roughly US$2.5 trillion of assets are under PE management.

However, PE transactions outside North America and Western Europe are still relatively

few and only account for approximately 12% of the global LBO (Leveraged Buy-Out)

transactions in number and 9% in value over the period from 2001 to 2007. But this is

going to change now, recognizing growing PE investment activities into the emerging

markets. Without doubt, PE activities in emerging economies are expanding and

maturing, particularly for minority and growth capital investments, as stated in a

research report by the World Economic Forum in 2008. Taking the growth opportunities

within the regions Asia Pacific, Latin America and Middle East (Table 1), there is still

an investment backlog in emerging regions compared to the LBO levels in North

America and Europe (Figure 3).

Table 1: Real GDP chance (RREEF Research 2009)

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



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Figure 4: Growth of primary and secondary PE market (RREEF Research 2009)

What’s about the Private Equity industry trend in 2010? The Private Equity industry is

dominated by a small group of large firms whose core business is buyouts. With their

global reach, deep pockets, professional back office operations and sectorial expertise

they primarily drive the growth of this industry. Smaller players will be able to find

niches in specialist markets and industries, but they do not have a big impact on the

private equity industry. However, during the global economic downturn in the years

2008 and 2009, there have been a lot of speculations in the press that the private equity

model is dead. But after a phase of reflection and retrenchment there are signs that the

private equity industry is shaking off the credit crisis and the economic recession. Many

investors appear optimistic about the outlook for private equity again. Credit markets

are continuing to stabilize and the deal volume seems to be recovering during the year

2010. However, according to a research of Pricewaterhouse Coopers in late 2009

(Pricewaterhouse-Coopers 2009), over 80% of private equity funds expect the business

model to change in the future.

Expecting a more robust market for 2010, there will be opportunities for PE firms to

make smart acquisitions at bargain prices. However, the past experience of the

economic and financial crises has limited the financing options. The request for larger

equity contributions will lower the leverage of acquisitions. Politics and society demand

for greater transparency and more robust reporting within the private equity industry.

Table 2 illustrates a summary of some future trends for the private equity industry.



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IN OUT

Liquidity (e.g., liquidity events,

available capital)

Illiquidity (e.g., near complete

absence of capital for financing or

equity investment)

More equity in LBOs (e.g., co-

investment capital)

Excessive leverage

Registration, reporting and

transparency requirements

Megacap buyouts

Secondaries in private equity Shorter duration private equity funds

Emerging markets become more

important

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



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3 Types of Private Equity transactions

Private equity transactions can be categorized best by the type of company the

investment is made in. Therefore it is helpful to look at the Product Life Cycle, which

can be thought of as the hunting ground of each of the main types of Private Equity

activity.

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

In other words, the type of Private Equity investment depends on the development stage

the company is in. A new company still getting started (“Introduction” stage) has low

cash flows, it not yet well established and investing in it bears a relatively high risk. On

the other hand the size of the investment will be relatively low in comparison to

investments in grown companies. When a company is for example in the “Maturity

stage”, it is probably well know, already in a strong cash position and will attract and

need other investors than companies that are still trying to establish a strong market

position in the “Growth stage”. Keeping the type of company, respectively the stage of

development in mind, three main types of Private Equity transactions can be identified:

Venture Capital transactions

Growth (Expansion) financing transactions

Acquisition / Buyout financing transactions

In the following chapters we want to look at the different types in more detail. As a

short overview, the three main types are compared against each other based on a couple

of criteria in Table 3.



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Criterion Venture Capital Growth Acquisition / Buyout

Companiestargeted

Start-up companies,companies in earlystages of development

Establishedcompanies that needto at least stabilizetheir market position

and grow

Mature / establishedcompanies

Reason forinvesting

Build company,make a business outof ideas, getcompanies started

Make companiesmore profitable,bigger, morevaluable; growcompany e.g. to gopublic or be sold

Buy the company orbuy and resell it toother company; goingprivate

Operationalcontrol

More guidance thancontrol onmanagement /

operations

Little influence onmanagement,investors role is

mainly to providecash

Depends on type of investor: strategic orfinancial investor

Risk involved High due to “infantmortality”

Low risk Medium to low risk

Use of leverage Almost never Mostly not Almost always

Size of investment

US$50,000 - US$5m US$5m – US$50m US$2m – US$200m+

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

3.1

Venture Capital

Venture Capital investments target either start-ups that have just developed an business

idea and / or a business plan or young companies that are in their early stages of

development and are in need to get started. These companies usually bear strong

technological risks, have high R&D expenses or have important investments in

equipment, intellectual property and more generally in immobilizations. The main

industries VC investments were made in the last couple of years are information

technology (IT), life science (LS) and clean technologies. For example venture capital

investments in 2008 in Europe were done by 56.8% in the IT sector, by 16.5% in the LS

sector.

Funding to build a company from scratch with only ideas and a business plan in the

back are called seed funding. Seed funding is mostly done by the founders themselves -

often through securing bank loans against personal collateral, friends, family members

or business angels, who specialized in finance innovating start-ups. Business angels are

usually former entrepreneurs or executives who turned out to be high net worth

individuals. The goal of seed funding is the development of the first business structures



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from ideas and business plans, to gather the initial capital, acquire key human resources

and identify early business partners. Seed investing is one of the least favored areas of

investing because the death rate of the companies in these stages are relatively high and

returns are usually received after a period over more than five years.

Seed funding is crucial for businesses because it shapes the future company. To provide

innovative ideas and companies a platform for development, many countries try to

replicate the Silicon Valley idea by building “technoparks” (Switzerland) or “capuses”

(UK) where solid infrastructure, a pool of investment and human resources are gathered

together.

In addition to private investors we have venture capital funds which are “formal

business entities in which full-time professionals seek out and fund promisingventures”. (Megginson et al. 2008, 475) Megginson et al. identify four different types of

VC funds: small business investment companies (SBICs; federal charted corporations),

financial venture capital funds (subsidiaries of financial institutions), corporate venture

capital funds (subsidiaries or stand-alone firms of non-financial corporations, e.g. Intel

Capital, Siemens Ventures) and venture capital limited partnerships (funds established

by professional venture capital firms). For further details we refer to (Megginson et al.

2008).

To minimize the risks of venture capital investments many investors do not only

providing financial help but also soft capital. They help the company to find their first

customers for pilot projects, try to attract human resources in the company, provide for

example qualified lawyers and auditors and give guidance in general management

decisions. Investors often form venture syndicates because the different investors have

different expertise and know-how.

Normally several rounds of financing are needed to help a company to get to a stage

where it can survive on its own. Most of investors will provide at least 2 times of the

initial investment during the next periods. It depends on the speed of the development

and the outlook of the company’s future if a next round of funding will be granted or

given by the investors. If the company does not move forward as hope, investments will

be stopped and the company along with its business idea is very likely sentenced to

death.



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But not every start-up company needs venture capital to become successful. For

example Microsoft was not venture backed; it was financed through its first customer

(IBM). But also the amount / rounds of financing differs strongly between companies:

Google needed only 2 rounds of VC financing whereas FedEx needed 10 rounds of

financing. Therefore sometimes it is difficult to draw a straight line between VentureCapital investment and Growth Capital investment.

3.2 Growth (Expansion) Capital

Growth, Development or Expansion Capital is generally associated with companies that

are well established and already run a profitable business. These companies need capital

to expand their business and grow. For example they need to build new plants and

increase their level of production, develop new products, research new technologies orwant to enter new markets. Many companies in this stage are not granted sufficient bank

loans due to their size, their financial records or because banks associate still too high

risks with the company. This is where other players enter the game and provide these

companies with sufficient financing. In the past it was relatively difficult to identify

sources that were specialized on growth capital financing. Most of the time it was LBO

fund managers who decided to put money into companies. But over the last couple of

years some funds emerged out of industrial groups like 21 Investimenti (Italy) which

focused strongly on the mid-market. Also due to the development of the emerging

markets more and more companies need this kind of financing and the number of funds

specializing in this area of investment increases.

Investors of growth capital take minority as well as majority stakes in the investee

company. Normally no leverage is used because the target company needs a strong

financial position to finance its development. Depending on the success of the company

e.g. in gaining market share or enter a new market the revenues from growth capital

transactions can vary but will still be relatively low. But also the risk involved can be

categorized as low, because the company invested in is already an established company

and the chance of failure growth operations is not very high.

3.3 Acquisition / Buyout financing transactions

In general a buyout is considered as the “purchase of a company's shares in which the

acquiring party gains controlling interest of the targeted firm.” (Investopedia)Companies involved in buyouts are usually mature businesses which are able to



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generate sufficient profits to service the debt that is almost always issued in such a

transaction (see LBO, page 13). In former times the acquired companies were broken

up, sold in pieces and the cash generated was used to pay down the high leverage of the

transaction. Nowadays the focus lies more on adding value to the purchased company

and using the assets and the profit generated by the development of the company to paythe debt. The level of control taken by the Private Equity investor himself depends on

the reason behind the investment. Financial sponsors are only interested in securing the

profits and will most certainly not be involved in the management of the target company

personally. But to insure the success of their investments they will for example make a

deal with the management team to stay on board until the acquisition costs are leveled

out. On the other hand, a strategic investor will generally not be interested in keeping

the existing management team but will have “his” team to run operations after thetakeover to secure the success of the operation.

Buyouts happen for different reasons and in different forms. One main reason for a

company can be the wish to go private. Private companies don’t need to comply with

several restrictions and laws concerning reporting to government institutions and

stockholders. This is a way to save a lot of money. Also the management respectively

the owners can decide they want to focus more on running and growing the business

instead of complying with regulations.

We will now have a look at the different forms of buyouts.

In comparison to Venture Capital transactions, buyouts can’t be carried out without

issuing debt due to the size of the financial resources needed to acquire the target

company. This is actually one of the main ways in which one can distinguish Buyouts

from other forms of Private Equity transactions. Buyouts typically involve only a small

portion of Private Equity and a big portion of debt. This is the reason why the term LBO

(Leveraged Buyout) is often used for all buyouts. After the transaction, the investors

need to make sure that the company works profitable to be able to pay off the debt with

revenues generated out of the business. Therefore it is often the case that no matter what

special form of buyout happens, there are people involved who bring in their expertise

and advise the target company on how to generate sufficient profits. Actors in the LBO



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market are large Private Equity firms like the Blackstone Group1. Some of them have

also listed their funds like KKR2. The different players in the LBO market are merely

specialized either on the size of the target companies and / or on the industries the

companies are operating in.

A special form of an LBO is the Management Buyout (MBO) which will be discussed

in detail in Chapter 4. It basically means that the management team of a company or

parts of it, who have previously held a limited equity stake or no shareholding at all,

decide to acquire the company either from the parent company or from shareholders.

MBOs can arise out of a variety of reasons e.g. in case of a family business where there

are no obvious successors to take over the company. Another reason might be that the

company wants to restructure and get rid of a certain subsidiary which is then be

acquired by the management team. Historically these transactions were done by the new

owners themselves. However, in the last years it became more popular to involve

private equity firms to approach the target company and involve the new owners only at

the end of the acquisition process.

Another form of buyout is the Management Buy-in (MBI) which differs from the MBO

only in terms of the management team. The new owners were previous to the

transaction not a part of the management group and “bought their way in”. Individuals(mostly people who were involved in MBOs earlier on) interested in MBIs are most of

the time from the same industry as the target company and therefore have the necessary

expertise in the area the company operates in which reduces the risk of such a

transaction.

3.4 Other types of transactions

There are a lot of other types of private equity transactions and their categorization is

not consistent through literature. Nevertheless, the two types presented in this chapter

are the most relevant ones looking at the market.

1 http://www.blackstone.com2 http://www.kkr.com



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3.4.1 Secondary buyouts

“A ‘secondary buyout’ describes a transaction where an existing company created as a

consequence of a buyout backed by original private equity investors is sold to a new

buyer vehicle backed by new private equity investors.” (Yates et al. 2010)

Even though private equity funds are mostly considered an illiquid investment they can

be turned liquid through secondary buyouts. For example if a PE investor wants to sell

his part in the investee company there is significant number of secondary investors who

will take over this part. Of course this depends on the attractiveness of the investment

proposed. The market for secondary buyouts was not too strong a couple of years ago

but has increased over the last years.

3.4.2 Mezzanine Financing

Mezzanine finance got its name from its position on the balance sheet where it is

located between senior debt and equity. Another form of PE financing is Mezzanine

financing, which is strongly connected to buyouts. A “mezzanine investor will lend

money into a Buyout transaction, but with the right to convert all or part of it into shares

in the target company.” (Fraser-Sampson 2010) This type of financing can be used for

example to bridge the gap where senior creditors are reluctant to extend the debt and

stockholders are reluctant to accept the dilution of their equity position. There is a widearea of mezzanine lenders which include insurance companies, mezzanine funds,

venture capital firms or banks and other senior lenders.



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4 A typical MBO process

As defined in the previous chapter, MBO is a special form of a LBO in which the

existing Management team decides to acquire the company, usually in cooperation with

outside financiers. This acquisition process, which differs in some aspects from other

LBO-forms, will be described in the following by focusing on the participants as well as

on the organizational and financial flows.

Normally, the MBO is initiated by the Management Team3 who addresses its purchase

interest towards the current owner (letter of intent). The advantage of a MBO is the

existing knowledge of the Management about the company’s performance. This makes

the Due Diligence process less complicated and hence faster. The skills and the

knowledge of the management is one key success factor. The acquisition of thecompany (also called Target) is normally financed by a third party as it is highly

unlikely that the Management will have sufficient funds themselves to buy the Target

due to the high purchase price. In almost all buyouts, finance from external sources will

be required. Debt financing often covers only a small part of the investment, as MBOs

are considered too risky for a bank to give out loans. Thus, the management seeks for

private equity investors instead who invest for a proportion of the shares. For the

investors it is important to make sure that the Management is locked-in by its owninvestments. In this way, the risk of inappropriate management decisions can be

minimized. It is likely that the managements’ shares of the company increase in order to

maintain the management’s motivation to maximize the company value. The following

illustration visualizes the correlations between the participants in more detail.

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



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

The MBO-process is not consistently described through literature. However, the most

important phases can be categorized as Preparation, Transaction and Completion phase.

As mentioned before the MBO is initiated by the announcement of the offer, normally

in an informal way. During this preparation phase, negotiations about purchase price

and contracts already between seller and buyer begin. The management team starts

elaborating the Financing-Structure in order to define the most suitable balance between

Debt and Equity Finance in consideration of expected cash flows and risk. The

preparation of a Business Plan is an important tool to catch the attention of potential

investors. The management sets up a MBO-Team with key players within the company

who leads the MBO-process.

After selecting equity advisors who are crucial as external experts for such a complex

topic regarding taxation, legislation and finance, the transaction process begins. During

this second phase, the Shareholders’ Agreement is signed. This is the deal between the

private equity provider and the management relating to their subscription for shares in,

and the managements' employment by the new company. The second deal is the Sales

Contract between Newco and the seller for the acquisition of Target. Third agreements,

so called Loan Agreements, are those between Newco and the providers of finance for

the acquisition of Target.



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In the completion phase the Due Diligence starts. This process, however, is likely to be

limited as buyers have already full knowledge of the company. Thus, there is no

Principal-Agent issue, which is typical of other LBO-transactions. This is also a reason

why the seller often prefers MBO as exit strategy as it is less time consuming.

The following illustration describes these 3 phases and each single step in more detail.

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



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5 Private equity as a financing source

The idea of Private Equity is relative simple and theoretically quite effective4: “buying

underperforming companies”, or companies that have found their critical mass to

continue growing, “turning them round and selling on at a profit” (Private equity

takeovers 2007), looks to be the right solution in order to eliminate inefficiency and

maximize value. By doing so, they create more financial wealth, and not only for their

own investors, but also (at least theoretically) for those companies that are being

acquired.

The central question raised by Private Equity as a financing source is: Do PE

investments aggregate growth and stability in terms of value creation or is it just a

financial tool to make short-term profit for the Private Equity firms’ point of view? Orin other words: Are Private Equity firms only concerned to secure a high and fast return

on their investment?

Private capital is now center in the on-going examination of the global financial system,

especially since the recent financial crisis5, with a consequent interest of policy-makers

to understand the impact of both traditional financial institutions, such as banks and

insurance companies, and alternative investment asset classes, such as private equity

and venture capital, on the global economy.

The World Economic Forum (WEF) publishes a report on the global economic impact

of the PE seeing it as a financing activity every year. They analyze the consequences of

this relative new financing source for those companies who decide to use it. The WEF

have defined the outcome of the overall PE activities in few fields to understand the

effects of it as investing activity: “Management Performance, Productivity, Strategically

portfolio, Risk sharing", etc. (The Global Economic Impact of Private Equity Report

2009)

As financing activity, we could also analyze the following points as well: the impact of

Private Equity on innovation, employment and corporate governance.

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



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5.1 Key findings on Productivity and Management performance

1. Firms acquired by private equity groups experience productivity growth in the two-

year period after the transaction.

2. The roughly 1,400 private equity transactions involving US manufacturing firms from1980 to 2005 raised output by somewhere between US$ 4 billion and US$ 15 billion per

year as of 2007

3. Both targets and controls tend to share productivity gains with workers in the form of

higher wages

4. Private equity-owned firms are associated with high scores on a wide range of

management practices, especially operational management practices.

(The Global Economic Impact of Private Equity Report 2009, VII)

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

As a critical counter argument, it could be said, that the difference in management

practice scores between Private Equity and dispersed shareholding firms (including

publicly quoted firms) is insignificant, and that normally PE firms select



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underperforming companies, so this incremental in productivity as well as in the

management performance should not be surprising but expectable.

5.2 Key findings on Strategic Portfolio and continuity

If we have a look at Patent quantity, we can see that it does not change after PEtransactions. The patent portfolios of firms become even more focused in the years after

PE investments. It is said that PE firms display no social responsibility; they have no

interest in investing in training or plants, since such investments are costly and rewards

are deferred and they do not have a long term view concerning their investments.

Empirically, if we look into the patent quantity from the companies before and after the

acquisition, it is clear that the portfolios of firms become even more focused in the years

after the PE investments. That would not be the case in short term strategies but more

for long term views.

It is true that many times PE firms generate profits by sacrificing necessary long-run

investments, but those are being compensated for the complete portfolio leverage.

Short-termism has been the curse of many. PE finance, being “geared to quick profits,

perpetuates this failing by discouraging long-term planning” (Private equity takeovers

2007). But the so called “quick flips” (i.e. exits within two years of investment by

private equity fund) account only for 12% of deals and have decreased in the last few

years. However, they could be a reason of the bad reputation of PE. The reality shows a

different tendency: “PE investors have a long-term ownership bias. 58% of the private

equity funds’ investments are exited more than five years after the initial transaction”

(The Global Economic Impact of Private Equity Report 2009).

5.3

Key findings on employment

While it is true that many of the PE acquisitions may include job destruction in the short

term, it is on the other hand also apparent that inefficiency damages the company’s

financial situation and finally leads to unemployment on a much greater scale (see

Figure 9).

PE firms display no social responsibility and they main task is to eager a profit in their

transactions; as financing activity, it must be clear that the governance of the company

gets diluted and many of strategically decisions, also regarding employment

management normally get out of the control of the former owner.



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Figure 9: Manufacturing employment under private equity targets: year and as percentage of manufacturing sector employment (The Global Economic Impact of Private Equity Report 2009, 39)

In general it can be said that there are certain inherent risks by using Private Equity as

an alternative financing source to the traditional debt acquisition as i.e. using loans from

banks.

On the one hand introducing an active partner who can share ownership, financial and

management responsibilities can lead to a better company performance and generation

of profits. On the other hand it has to be understand, that the majority of PE activities in

the past led to a total control of the management activities and to a dilution of the firm

control.



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

Summarizing the previous chapters, the arguments for and against private equity as a

financing source are listed in the following table.

Pros Cons

Introducing an active partner who can

share ownership and management

responsibilities

You are accountable to other parties

Share financial responsibility with

other. Finance growth without

increasing personal debt

Control over the business and access

to the CF is diluted

Overcome the critical mass and

greater security for growth

Diluted control of your business

Inefficient companies damages the

financial situation on the company

and finally leads to unemployment

Restructuration may involve job

losses

PE investments make companies more

productive

PE firms display no social

responsibility

PE firms are significantly better

managed than government-owned,

family-owned and privately owned

firms

Normally PE firms seem to select

underperforming firms

Value-added implied by the

differential in productivity

Short-term financial goals at the

expense of operating performance.

PE investors have a long-term

ownership bias.

Main focus is to generate profits.

Some PE firms have only short term

focus

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



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Appendix



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

Financial Mgmt Assignment 2 - Private Equity

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