What is Private Equity?
- Private equity is an asset class that has evolved substantially in the last couple of decades.
- It is an alternative investment strategy that involves investing in privately held companies.
- The key feature is the private nature of the securities purchased.
- Investments in private equity are illiquid.
- Investors in this marketplace must be prepared to invest for the long-haul; investment horizons may be as long as 5 to 10 years.
Private Equity Partnership Structure
- The predominant organization form of private equity investing is the limited partnership structure.
- Limited partnership consists of limited partners (LP) and general partners (GP).
- The LPs of the partnership are the investors, i.e., the main providers of capital. These are typically wealthy individuals, endowments, pension funds, and other institutional investors.
- The GP of the partnership are responsible for the day to day management of the partnership’s investment, as well as general liability for any lawsuit that may be brought against the fund. LPs must not be actively involved in the day-to-day operations of the funds if they are to maintain limited liability status.
Classes within Private Equity
- Venture Capital
- Mezzanine Financing
- Leverage Buyouts
Leveraged Buyout Structures and Valuation
Reasons for Growth in Private, Leveraged Finance
- Regulatory Loopholes – securities law
- Tax subsidies for both leverage and fees
- Cheap debt globally, driven by flows of dollars resulting from global trade imbalances held by China, Japan into global debt markets.
- Depressed stock prices relative to debt.
- Pension crisis driven by labor market pressures, forcing pension managers to seek higher yields.
Problems with Private, Highly Leveraged Finance
- Lack of regulation and transparency breeds systemic risk.
- Cheap debt leads to overleveraged and firm and lender bankruptcy.
- Highly leveraged firms under invest, attack worker living standards.
- Fee structures and tax subsidies lead to concentration of wealth and political power, erosion of the tax base.
Learning Process
. The motivations of and methodologies employed by financial buyers;
. Advantages and disadvantages of LBOs as a deal structure;
. Alternative LBO models;
. The role of junk bonds in financing LBOs;
. Pre-LBO returns to target company shareholders;
. Post-buyout returns to LBO shareholders, and
. Alternative LBO valuation methods
. Basic decision rules for determining the attractiveness of LBO candidates
Financial Buyers
In a leveraged buyout, all of the stock, or assets, of a public corporation are bought by a small group of investors (“financial buyers”), usually including members of existing management. Financial buyers:
- Focus on ROE rather than ROA.
- Use other people’s money.
- Succeed through improved operational performance.
- Focus on targets having stable cash flow to meet debt service requirements.
- Typical targets are in mature industries (e.g., retailing, textiles, food processing, apparel, and soft drinks)
Leveraged Buyouts (LBO)
- LBOs are a way to take a public company private, or put a company in the hands of the current management, MBO.
- LBOs are financed with large amounts of borrowing (leverage), hence its name.
- LBOs use the assets or cash flows of the company to secure debt financing, bonds or bank loans, to purchase the outstanding equity of the company.
- After the buyout, control of the company is concentrated in the hands of the LBO firm and management, and there is no public stock outstanding.
Successful LBO Strategies
- Finding cheap assets – buying low and selling high (value arbitrage or multiple expansion).
- Unlocking value through restructuring:
> Financial restructuring of balance sheet – improved combination of debt and equity
> Operational restructuring – improving operations to increase cash flows
Value Creation
. Management incentives and agency cost effects
> Increased ownership stake may provide increased incentives for improved performance
- Better aligns manager / shareholder interests
- Lower agency costs of free cash flows: debt from LBO commits cash flows to debt
- Debt puts pressure on managers to improve firm performance to avoid bankruptcy
. Wealth transfer
> Wealth transfer from current employees to new investors – low management turnover (but sometimes new mgmt. team), slower growth in number of employees
> Tax benefits in LBO constitute subsidy from public and loss of revenue to government – LBO premiums positively related to tax benefit
- Net effect of LBO on government tax revenues may be positive due to gains to shareholders and increased profitability
- Many of tax benefits could be realized without LBOs
. Asymmetric information and under pricing
> Managers, investor groups have better information on value of firm than shareholders
> Large premium signals that future operating income will be larger than expectations – investor group believes new company is worth more than purchase price
. Other efficiency considerations
> More efficient decision process as private firm
> Influence of favorable economic environment
LBO Deal Structure
> Advantages include the following:
- Management incentives,
- Tax savings from interest expense and depreciation from asset write-up,
- More efficient decision processes under private ownership,
- A potential improvement in operating performance, and
- Serving as a takeover defense by eliminating public investors
> Disadvantages include the following:
- High fixed costs of debt,
- Vulnerability to business cycle fluctuations and competitor actions,
- Not appropriate for firms with high growth prospects or high business risk, and
- Potential difficulties in raising capital.
Classic LBO Models: Late 1970s and Early 1980s
> Debt normally 4 to 5 times equity. Debt amortized over no more than 10 years.
> Existing corporate management encouraged to participate.
> Complex capital structure: As percent of total funds raised
- Senior debt (60%)
- Subordinated debt (26%)
- Preferred stock (9%)
- Common equity (5%)
> Firm frequently taken public within seven years as tax benefits diminish
Break-Up LBO Model (Late 1980s)
> Same as classic LBO but debt serviced from operating cash flow and asset sales
> Changes in tax laws reduced popularity of this approach
- Asset sales immediately upon closing of the transaction no longer deemed tax-free
- Previously could buy stock in a company and sell the assets. Any gain on asset sales was offset by a mirrored reduction in the value of the stock.
Strategic LBO Model (1990s)
- Exit strategy is via IPO
- D/E ratios lower so as not to depress EPS
- Financial buyers provide the expertise to grow earnings
. Previously, their expertise focused on capital structure
- Deals structured so that debt repayment not required until 10 years after the transaction to reduce pressure on immediate performance improvement
- Buyout firms often purchase a firm as a platform for leveraged buyouts of other firms in the same industry
Role of Junk Bonds in Financing LBOs
- Junk bonds are non-rated debt.
. Bond quality varies widely
. Interest rates usually 3-5 percentage points above the prime rate
- Bridge or interim financing was obtained in LBO transactions to close the transaction quickly because of the extended period of time required to issue “junk” bonds.
. These high yielding bonds represented permanent financing for the LBO
- Junk bond financing for LBOs dried up due to the following:
. A series of defaults of over-leveraged firms in the late 1980s
. Insider trading and fraud at such companies a Drexel Burnham, the primary market maker for junk bonds
- Junk bond financing is highly cyclical, tapering off as the economy goes into recession and fears of increasing default rates escalate
Factors Affecting Pre-Buyout Returns
- Premium paid to target firm shareholders consistently exceeds 40%
- These returns reflect the following (in descending order of importance):
. Anticipated improvement in efficiency and tax benefits
. Wealth transfer effects
. Superior Knowledge
. More efficient decision-making
Factors Determining Post-Buyout Returns
- Empirical studies show investors earn abnormal post-buyout returns
- Full effect of increased operating efficiency not reflected in the pre-LBO premium.
- Studies may be subject to “selection bias,” i.e., only LBOs that are successful are able to undertake secondary public offerings.
- Abnormal returns may also reflect the acquisition of many LBOs 3 years after taken public.