Private Equity : An Overview
Professor Eli Talmor
September 2011
Institutional Private Equity Has
Become a Distinct Asset Class
$2.5 trillion asset under management
and committed capital (“dry powder”)
20 largest public US pension funds have $111 billion in
PE on behalf of 10.5 million beneficiaries
Growth and value investments across a
wide range of industries
Investments in all stages of corporate
lifecycle
2
Compared with public equities, PE
outperformed
Source: Bain & Company (2010) 3
UK Private Equity Performance vs. Principal
Pension Comparators to December 2010
Source: BVCA, Capital Dynamics & PWC Annual Performance Measure Survey, August 2011
4
UK PE Performance since inception
by vintage year to December 2010
Source: BVCA, Capital Dynamics & PWC Annual Performance Measure Survey, August 2011
5
Academic evidence on private
equity performance
“There is a general consensus across different
methodologies, measures and time periods
regarding a key stylized fact: LBOs and
especially MBOs enhance performance and have
a salient effect on work practices.” Cumming,
Siegel, Wright (2007)
Caveat – public-to-privates appear to be
different
6
From an esoteric player in the early 80s
to a leading market force today
4270 private Equity Funds
25% of global M&A
50% of leverage loan volume
33% of high-yield bond market
30% of initial public offerings market
Morgan Stanley, Triago, Preqin
7
Private Equity Penetration (2009–2010)
Annual private equity investment as percentage of GDP
1.20
1.13
1.00
0.90
0.80
PE Investment/GDP (%)
2009
0.63
2010
0.60 0.57
0.43 0.44
0.40 0.34
0.32
0.26
0.23
0.21
0.20 0.16 0.16
0.13 0.11
0.10
0.06 0.08 0.06 0.06 0.08
0.06
0.04 0.04
0.02 0.01 0.01 0.01 0.01 0.01
0.00
United United Israel India Brazil China Russia Poland SSA South Japan MENA Mexico South Turkey
Kingdom States Korea Africa
© Emerging Markets Private Equity Association. Data as of 31 December 2010. Published 25 August 2011. 8
Quoted stocks vs. private equity
The three pillars of public equity
markets
Non predictability of returns
Diversification
No Arbitrage
All three are violated in Private Equity
Persistence of Returns
Larger, illiquid investments
All forms of Arbitrage: Governance,
Regulatory, Leverage, Tax
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What is PE?
In what to invest?
Who invests?
What percentage?
Illiquidity?
Fund structure, horizon
Hands on, involvement
Strategic?
Legal Structure (1)
Investments in private equity are
typically non quoted
Predominant organization form is the
limited partnership structure
5-10 (+1+1) year horizon, then self
dissolving.
Limited partnerships consist of limited
partners (LP) and general partners (GP)
11 11
Legal Structure (2)
INVESTORS/ LIMITED
PARTNERS
(Capital)
MANAGER/
GENERAL PARTNER
(Expertise) FUND
PORTFOLIO COMPANIES
12
What do the investors get?
Their investment back
All profits up to an agreed level
Known as the “preferred return” or “hurdle”
Requires GP to outperform less risky investments
Typically 8% compounded per annum on commitments
drawn down but not yet repaid
80% of any profits in excess of the hurdle
Usually, once GP has “caught up” preferred return
13
What does the GP get?
Management fee (annually)
Around 1.2-1.5% for megafunds
Typically 1.5% - 2% for mid-market buyout funds
Up to 2.5% for venture funds and emerging market funds
Carried interest
Form of performance fee
Typically 20% of the fund’s net profits
Only paid once investors have received a minimum return
Deal by deal (a US system) or at fund level profit level (a
European system)
Trans fees for corp. fin. activities (1-1.5% of EV)
Return on co-investment interest
14
Private Equity Invests at All Stages of
the Corporate Life Cycle
Seed/Start- Expansion Liquidity Event (e.g.,
up Capital IPO, Strategic Sale, etc,)
Follow-on Bridge/
Venture Mezzanine
Buyout Distressed
Financing
Concept Development Later Stage Reengineering/
Stage Stage Restructuring
15
Private Equity vs. Venture Capital
Except for the dot com years, international
“Venture Capital” dominated by buyouts
(LBOs)
restructuring, MBOs
Expansion Capital
companies relatively big and old
Confusing Terminology:
VC (Eur., Asia, Afr.) = Private Equity (US)
16
Alternative Assets Class
7 – 10 Angel
years Investors
Early
Stage Buyout
Venture Firms
3–7
years Growth
Equity
Time to
Liquidity
Late Stage
Active / Venture
Distresse
1–3 d Assets
years HF
Passive
Hedge
Quarterly Funds
Small % 10 - 35% 35 - 50% 50 -75% 75-100%
Ownership stake
17
Private Equity Value Chain: 5 steps
Screeni Executin Adding Harvesti
Sourcing
ng g Value ng
Finding the Evaluation Getting it Build economic Money back
deals done value
Angle Re-cap?
- Proprietary Nail the due …within the
WHYTB: key IPO
deal flow? diligence business
issues for Full sale
- Auction (legal, fin., Organic
strategic DD) -
processes IT, HR, growth - Trade sale
Financing insurance,
Have M&A
package etc.)
- - Secondary
investment - Strategic buyout
Theses Fit All
the repositioning /
• Specific Assess elements in divestment
sectors chance to win place …through the
• Size - Equity financing and
• Geography - Structured the final sale
Debt process
- Regulatory
sign off?
18
Winning PE firms need differentiated
investment capabilities
Source: Bain & Company (2010)
19
Diametrically Opposite Investment
Strategies
KKR Fidelity
Companies Held* 60 Over
7,000
Board Seats 100% 0%
* September 2011
20
Private equity has transformed the
DNA of corporate governance
A small “workshop” board concentration of
ownership and control
Focus on exit / short time horizon
High power compensation »» self selection of
managers
Alignment of incentives
Expectations are not managed by financial
analysts
21
Private Equity Firms Can Attract the
Best Investing Talent
Flexibility
Compensation
Carried interest
Ability to create high profile brand
22
The Upper Quartile Syndrome
$160
Average Distributions by Year
$140
$120
$100
$ in Millions
First Quartile
$80
$60
$40
$45 mln
All Other
$20
$0
90 92 94 96 98 00 02 04 06
Source: Venture Economics
23
Performance Persistence: Are there good
GPs? Yes!
Next Time Tercile High likelihood that the next
funds of a partnership stays
in the same performance
Bottom Medium Top bracket
Bottom
Tercile 61% 22% 17% Persistence
At the top and bottom
Medium
Tercile 25% 45% 30% Persistence for top quartile
funds remains even in
market downturns!
Top Tercile 27% 24% 48%
Source: Kaplan and Schoar, 2005
24
Risk and Diversification
Precise standard deviation is practically impossible to
measure
However strong evidence on risk reduction through
asset allocation
1 Long term horizon 30 years, short term horizon 19 years.
2 Long term horizon 24 years, short term horizon 16 years.
Source: NVCA
25
Diversification Gains of Private Equity
Allocations
26
Private Equity within Asset Allocation
Source: HarbourVest
27
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Private Equity Increasingly Raising
Investor Capital at the Retail Level
Fund of funds lower minimum investment
for smaller investors or provide diversity,
access, management for larger investors
Incremental level of “fees for
management”
Alternatively, to buy listed funds:
Blackstone, Apollo, Ripplewood, Carlyle,
etc.
29
UBS Four Main Pillars for PE
Portfolio Diversification
Vintage North America
years 2007, Vintage Geography Europe
2008, 2009 Asia
& 2010
Diversified
Private
Equity
Range of
Portfolio
managers in Venture Capital
each geography, Manager Strategy Buyout
strategy and Growth Capital
vintage Special Situation
Source: UBS Marketing Presentation (2006)
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