feature article international imaging technology council...regardless of whether lbos are at their...

Feature Article

32 Imaging Spectrum ✴ August 2007 ✴ International Imaging Technology Council ✴ www.i-itc.org

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International Imaging Technology Council

032-39 Stein - PE 8-07.qxp 7/16/07 3:38 PM Page 32

www.i-itc.org ✴ International Imaging Technology Council ✴ August 2007 ✴ Imaging Spectrum 33

How Private Equity Really Works (Part 1 of 2)by Martin Stein, Managing Director, Blackford Capital, Tony Kiehn, Managing Director, Blackford Capitaland Jennifer Danzi, Marketing Analyst, Blackford Capital

Leveraged buy-outs (LBOs), in which an existing companyis acquired using a combination of debt and equity, totaledjust under $60 billion of transactions in 2002. In 2006,

LBOs accounted for more than $400 billion of transactions. In thefirst half of 2007, there have been over $335 billion of LBO trans-actions. Looking forward to 2008 and beyond, one might assumethat the volume of LBO activity will only increase. However, LBOsare cyclical and the current cycle, the biggest ever, is bound tocome to an end given the potential for increased interest rates,proposed tax increases, and increased competition.

Regardless of whether LBOs are at their peak today, tomorrow oryesterday, savvy business executives are well-served knowing moreabout the mechanics of private equity firms and how a leveragedbuyout works. Several private equity groups (“PEGs”) have madeforays into the compatible imaging supplies industry in recent years(Hyde Park Holdings, Key Capital Partners, Stonehenge Capital,Kayne Anderson and Blackford Capital, among others), severalmore have investigated the industry and, no doubt, a few more willstill contemplate making future investments.

In a two-part series, this article will provide entrepreneurs and busi-ness owners with a basic understanding of the mechanics of a lever-aged buyout, offer information to both buyers and sellers on theprocess of a transaction and articulate the philosophy or point ofview of a private equity firm as they evaluate any given transaction.

What Is Private Equity?Private equity, as its name suggests, is private, which means it is notsubject to ownership or results reporting, SEC filings (except whenacquiring public entities) or other public disclosure regulations.Interestingly, two of the largest private equity firms (Blackstoneand KKR) have recently completed or announced initial publicofferings. As its name also implies, private equity typically involvesequity (not debt) investments. However many, if not most, privateequity firms also provide debt financing for businesses.

There are a variety of different types of private equity transactions—the term is used loosely to describe any capital providers that are not

public as well as a host of players involved in some form of transac-tional events, financial solutions or participation in the capital struc-ture of businesses. Generally, private equity refers to leveragedbuyouts, seed investments, venture capital, angel investing, growthcapital and other various forms of financing or investing.

Private equity can be categorized by the size of investment, type ofinvestment, target rate of return, investment horizon, source of cap-ital, number of investments per year and location within the capitalstructure, among other factors. There are approximately 1,000 to2,000 private equity firms within the United States with approxi-mately $200 billion of uninvested equity capital available for acqui-sitions and investments. Most private equity firms manage capitalfrom both wealthy individuals and from institutions.

Two of the largest categories of private equity firms are venture cap-ital firms and LBO firms. Venture capital firms provide financing tostart-up businesses that need seed financing to grow. LBO firmsacquire existing businesses with a combination of debt and equityand work aggressively to improve the value of the companies theyacquire over a three- to seven-year period.

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Jennifer Dazi is a marketing analyst at Blackford Capital. She currently attends Williams College and the LondonSchool of Economics.

Tony Kiehn is a managing director at Blackford Capital. Kiehn led Blackford Capital’s sale of Rhinotek to ReliantEquity Investors. Kiehn has 10 years of experience working in Asia. He is a graduate of Harvard Business School and the

University of Nebraska.

Martin Stein is the managing director of Blackford Capital, a private equity firm focused on middle-mar-ket acquisitions, and serves as treasurer on the executive board of the International Imaging Technology

Council. Previously, he served as president of Quality Imaging Products. Stein has received numerousindustry leadership awards and has substantial private equity, investment banking, operations and con-

sulting experience. He has published several Harvard Business School cases and received his MBA fromHarvard Business School and his BA from the University of Chicago.


International Imaging Technology CouncilFeature Article


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Private Equity is Big—and Growing Even BiggerAs Chart 1: Private Equity Invested reveals, the private equity indus-try grew from $1 billion of equity invested in 1993 to approximately$15 billion in 2000 and was fueled, in large part, by the venturecapital community. From 2001 to 2007, equity investments grew from$8.5 billion to $85 billion, fueled almost entirely by leveraged buyouts.

Chart 2: The Biggest LBOs of All Time provides a dramatic demon-stration of the recent rise of LBO transactions. The numbers arequite impressive. As of July 3, five of the biggest LBOs have been in2007, four were in 2006, and one is the historic KKR deal immortal-ized in the legendary business book, “Barbarians at the Gate.” Arti-cles in leading publications also point to the hot industry market(see sidebar,“Private Equity Makes Headlines”).

Even more compelling is the data on Chart 3: Available Private Equi-ty Capital. The total amount of uninvested capital has increasedfrom $35 billion in 1990 to $180 billion today. Uninvested capital isused to denote the amount of available funds targeted to be invest-ed—this number effectively represents the available “capacity” fortransactions. Uninvested capital is a trailing figure (note the lowestlevel is in 2004, several years after the industry peak), but it is high-ly meaningful because it sets the stage for coming years. From 1990to 1995, the amount of uninvested capital grew from $35 billion to$40 billion, approximately 3 percent per year. From 1995 to 2007, theamount of uninvested capital grew from $40 billion to $180 billion,approximately 70 percent per year.

How Private Equity WorksPrivate equity firms (both LBO and venture capital) are responsible for:

• Sourcing transactions• Due diligence/completing investments• Ensuring the success of the portfolio companies• Exiting the investment

Private Equity Makes Headlines

Readers of the business press need not look far to find coverage on pri-

vate equity. Fortune, Forbes, the Wall Street Journal, BusinessWeek,

the New York Times, the Financial Times, and a host of other periodicals

and newspapers have provided extensive coverage of private equity deals

and firms over the past several years. The Blackstone Group’s initial public

offering was the largest IPO in the past five years and, arguably, one of

the biggest business stories of the year, further highlighting the role pri-

vate equity has come to play in the capital markets.

• Blackstone IP is hot, hot—Globe and Mail, 6/22/07

• US M&A Hits $1 Trillion in Record Pace—Financial News Online US, UK, 6/28/07

• Private Equity M&A In US Accounts For 35% Of Overall Activity, Up From 16%

A Year Ago—Thompson Financial, 5/22/07

• The 2000s M&A Boom Has Arrived—Wall Street Journal, 6/27/06

• Worldwide Strategic M&A Total $1.7 Trillion, A 69% Increase From Last Year—

Thompson Financial, 5/22/07

• Private Equity Buyouts Soar,While IPOs and Exits Slow—Wall Street Journal,

7/14/06

• Private Equity Buyers Are Creeping Into Non-Private Equity Sectors Such As

Financials, Energy and Power, High Tech, and Telecom—Thompson Financial,

5/22/07

• Blackstone Buyout Fund Hits Industry High $15.6 Billion—Wall Street Journal,

7/12/06

• Attracting Private Equity Becomes A National Sport In Europe—New York

Times, 6/29/07

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Stein: How Private Equity Really Works (Part 1)

Each of these activities involves a very distinct set of skills and capa-bilities and will often have different team members involved.

Sourcing TransactionsThere are between 4,000 and 8,000 middle market merger andacquistion (M&A) transactions completed per year in the UnitedStates. There are many more acquisitions by individual buyers. Themiddle market typically refers to transactions ranging from $10million to $500 million. Most middle market transactions are notcompleted, so there are roughly 10,000 to 20,000 deals brought tomarket each year. As Chart 4: Total Number of US M&A Transac-tions Completed Each Year indicates, several hundred of these dealsexceed $500 million in value. Approximately 1,000 of these deals are

between $100 to $500 million in value and are called “middle mar-ket” deals. The vast majority of completed transactions are for lessthan $100 million. Deals less than $100 million in value are referredto as “lower middle market.” Additionally, an even larger number ofacquisitions are never recorded because they occur between indi-viduals or are unannounced. Private equity firms are responsiblefor roughly 20 percent of the transactions, while corporate buyersaccount or the remaining 80 percent.

Chart 5: Sourcing Transactions—The Deal Pipeline provides detailon the number of transactions a private equity firm will investigateto close on a new platform company. A typical private equity firm

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(LBO) in the lower middle market might evaluate 1,000 to 3,000deals per year (roughly one-quarter to one-half of the total dealsbrought to market, if the PEG is in touch with the right intermedi-aries such as bankers, accountants, and lawyers). Of those, between5 percent and 10 percent (some 50 to 300) actually meet the firm’scriteria. The largest venture capital firms will see even higher num-bers of deals from all of the start-up business plans and miscella-neous deals that are submitted to them. Larger LBO firms evaluating$500+-million-sized transactions will look at a smaller number ofdeals given the fact that their universe is smaller—there are only somany $500+ million deals per year.

Once a private equity firm has determined that the deal fits its crite-ria (size, industry, growth, earnings, management team, etc.) and,more importantly, they believe the company has the potential toincrease in value, the PEG will schedule a meeting with the manage-ment team to get additional information. PEGs may schedule meet-ings with between 5 percent and 50 percent of the firms that meettheir initial criteria, depending upon how strict their criteria are.These meetings can be short or long, but in order to be productivethey almost always involve the exchange of financial information.

After a preliminary meeting, the PEG will evaluate the business, theindustry, the management team, and the opportunity to increasethe value of the business. If the PEG believes there is an opportuni-ty to increase the value of the company and the shareholders have areasonable expectation of value, the PEG will submit a Letter ofIntent (“LOI”) based upon the feedback or direction from theshareholders (see sidebar,“Interpreting an LOI”). Typically, an LOIis a serious indication of a desire to move forward on the part of theprivate equity firm. Once an LOI is signed—most are non-bind-ing—the shareholders of the firm and the PEG will work throughadditional due diligence needs over a 60- to 120-day period to con-summate the transaction.

Due Diligence/Completing TransactionsChart 6: A Typical Due Diligence Process for a Private Equity Firmdelineates the seven mission-critical steps a PEG will need to completeduring due diligence to consummate a transaction.From start to close,a well-managed transaction should take approximately 16 weeks. Pri-vate equity firms may take four weeks to present an LOI (although thisprocess can certainly take longer) and then 12 weeks (approximately75 to 90 days) following the signing of a LOI to complete a transaction.The schedule in Chart 6 assumes that the entire process (including ini-tial introduction to the company) begins on Jan. 1.

Interpreting an LOIA Letter of Intent (LOI) is a non-binding indication of

interest based on a private equity group’s (PEG’s) desire to

acquire or make an investment in a particular company.

LOIs are based on the information made available to the

PEG.The more information that the PEG has received, the

stronger the LOI; the less information, the weaker the LOI.

LOIs typically range in length from one to 15 pages. Short

LOIs are not necessarily better or worse than long LOIs,

although, as one might assume, the more details that are

addressed in the LOI, the fewer the details that will need

to be addressed later.

LOIs often contain the following elements pertaining to

the transaction:

• Price of a Deal—What is the value of the entity?

How is it being valued?

• Structure of the Transaction—How will the deal be

structured? Cash at close? Payments over time?

• Terms of the Deal—What assets are being acquired

(if the deal is not a stock deal)? What liabilities are

being assumed? Is there a working capital amount

that is specified in the transaction?

• Timeline—When is the transaction expected to

close?

• Conditions to Close—What activities need to be

completed in order to close the transaction? Are there

any particular activities that would prevent a transac-

tion from being closed? Must the business meet a

certain performance requirement?

• Due Diligence Process—What will occur during the

due diligence process? Will employees, customers and

suppliers be contacted? Will there be an environmen-





Immediately following the signing of the LOI, the PEG will beginto complete the financial model/operational plan for the business.This process requires involvement by the company’s managementteam and, potentially, its shareholders (frequently the same peo-ple in small enterprises). In this process, PEGs are looking to testtheir initial hypotheses about the potential future financial per-

formance of the business. PEGs will invest a significant amount oftime in the financial analysis of the business, testing questionssuch as:

• Revenues—How many current customers are there? Whathave the average sales of each customer been? What will they

tal audit? A legal audit? A financial audit? Operational

and IT audits?

Additionally, LOIs include the following components,

which benefit both the PEG and the selling shareholders:

• Non-Compete—If the owner is leaving the business

(or may leave the business), PEGs will require a strong

non-compete to ensure that the owner or shareholders

do not receive money for the purchase of their business

and then go out and directly compete with it. Clearly,

most well-intentioned owners would never do this.

• Confidentiality—Often, a non-disclosure or confi-

dentiality agreement has already been signed, yet the

LOI will reaffirm the intention of both parties to keep

the information exchanged confidential. LOIs that do

not come to fruition are best left undisclosed for all

parties involved.

• Exclusivity—PEGs will insist upon exclusivity for

selling shareholders. From the point of view of a PEG,

an LOI without a period of exclusivity is meaningless

(for private transactions, public transactions have a

different process). PEGs will spend anywhere from

$50,000 to $1 million and 1,000 to 4,000 hours dur-

ing the due diligence process. PEGs are much less

inclined to make this investment in a transaction if

the selling shareholders will not agree to a period of

exclusivity while the PEG is making this investment.

The first draft of an LOI should be perceived by selling

shareholders as a starting point for dialog about a trans-

action. Most PEGs are open and willing to make modifica-

tions to an offer, based on the interests of the selling

shareholder. By definition, LOIs are legal documents, which

means they can be a little dry and unintentionally dis-

tancing for those not familiar with their language, struc-

ture and scope.

If an LOI takes six or more drafts or two or more months to

get negotiated, it often signals an unwillingness on the part

of both parties to come to a mutually satisfactory agree-

ment. Conversely, LOIs that are signed on the first draft

within a day or two of being presented may not be particu-

larly meaningful if both parties have not fully explored and

discussed all of the components of the LOI.




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be in the future? What are the sources of revenue? How is theproduct/service mix changing?

• Cost of Good Sold—What is the cost structure for the busi-ness? How volatile are the costs? Will costs increase ordecrease? What are the general trends for the business costs?What will affect material costs? What is happening with labor?Is labor increasing or decreasing productivity? Are there fixedcosts? Are there economies of scale?

• Operating Expenses—What functions do the various man-agement team members serve? How much are they paid forthese functions? What is the structure of the sales team? Howmuch advertising is required? Will additional investmentsyield increased results?

Many PEGs will test the hypotheses for the business with rigorousanalysis involving customers, vendors, employees and outsideindustry analysts. Typically, PEGs will require a substantial amountof data to complete their analysis. The company will need to beintimately involved in providing this information, and most PEGs(or buyers, for that matter), will not engage outside serviceproviders until they have received, processed, and digested theinformation presented to them. This completes roughly the firstthird of the transaction.

The second third of the transaction involves the outside serviceproviders, such as accountants, lawyers, and other miscellaneousconsultants. PEGs will select the number of outside consultantsbased upon the size of the transaction, the risk factors identified, thefinancial model, and the information accumulated during the initialdue diligence. Acquirers of businesses can spend anywhere from

$10,000 to $500,000 on this portion of the transaction. Generally,the outside consultants, lawyers and accountants are confirming theinformation that has been presented. All parties (buyers and sellers)want to ensure that there are no surprises.

The final third of the transaction is financing and documentation.In most LBOs, PEGs will use debt both to satisfy the purchase pricerequirements of the seller and to increase their returns. Typically,sellers prefer a higher price than what equity returns alone wouldjustify. As a result, buyers are forced to finance a transaction withdebt. Similarly, buyers have certain thresholds for returns thatrequire them to use debt to finance a transaction. If a buyer pur-chased a business entirely with equity, the performance of the busi-ness would need to be incredibly high in order for the buyer toachieve the necessary returns.

Bank financing is not a complex process for a good business and agood private equity firm. Banks will provide debt based on assetsand cash flows. Businesses with poor cash flows (low profitability)or limited assets will have difficulty getting financed. Additionally,businesses with less than $2 million of earnings before interest,taxes, depreciation and amortization (EBITDA) have difficulty get-ting financed because they are perceived as quite risky businesses.Larger deals are much easier to get done. Banks can take three toeight weeks to complete their own due diligence and agree tofinancing commitments.

The documentation process involves the drafting, editing and sign-ing of the asset or stock purchase agreement. The terms of the APAshould roughly mirror the terms of the Letter of Intent. However,oftentimes during the due diligence process, buyers will identifyfinancial costs, litigation, or other risk factors not previously dis-closed that require an adjustment in the price and/or structure ofthe transaction.

For example, the owner may have suggested that the financial sys-tem would need to be upgraded prior to the signing of the LOI, buthe did not inform the buyer that the system was a $100 off-the-shelf product that froze multiple times a day, did not permitmonthly closings, and/or have a general ledger that was off byapproximately $1 million, a material amount. Alternatively, theseller may have informed the buyer that the inventory was valuedaccurately, yet the buyer identified $2 million worth of non-virgininkjet cores that were completely unusable and would need to bewritten off. Neither of these factors should be deal killers. Howev-er, they do represent material findings that could negatively impairthe value of the entity being acquired.

In addition to an asset purchase agreement, documentation mayalso, but does not necessarily, involve the following legal documents:

• Employment Agreements—a potential agreement with thechief principals remaining after the transaction that governs





the relationship post transactionbetween the acquirer and the principal.

• Non-compete Agreement—a poten-tial agreement that determines thelength of time, after exiting the firm,that principals will not work in director indirect competition with the busi-ness they sold.

• Disclosure Schedules—potentialdocumentation that supports the assetpurchase agreement and providesdetails about the business. Schedulesprovide representation on inventory,accounts receivable, litigation andmany other facets of the business.

• Loan Documents—If debt is used inthe transaction, there will be loan doc-uments that detail the loan provisions,covenants, terms, price and other vari-ables associated with the loan.

• Miscellaneous Agreements—Thereare other specific documents that maybe required for both buyers and sellersto complete, including shareholderconsents, board approval of the trans-action, and assignment and assump-tion documents.

Ensuring the Successof Portfolio CompaniesA typical private equity firm will managebetween three and 40 portfolio companiesat one time. Some larger, well-establishedfunds could potentially have more portfoliocompanies, and select smaller funds with amore limited focus or a firm that was exit-ing its investments could manage fewerportfolio companies.

Typically, private equity firms hold posi-tions on the boards of their portfoliocompanies with quarterly in-personmeetings. At the early stages of an invest-ment, PEGs may look for weekly resultsreports and performance reviews. Assum-ing a portfolio company is doing well,PEGs will become less involved as themanagement team achieves the targetedresults. PEGs are responsible for ensuring

that management is successful, but theyare not necessarily responsible for manag-ing the business itself. If management isnot doing well, PEGs may be required tofind new management for a business.

Given that PEGs look at an investment for athree- to seven-year horizon, with a usualtarget of five years, one year of missedresults translates into a 20 percent setback(one year divided by five years) on the lifeof the investment. Every quarter represents5 percent of the investment horizon. There-fore, a PEG is not likely to let more than sev-eral quarters of missed results transpirebefore needing to seriously evaluate themanagement team.

Exiting the InvestmentAfter a company has achieved its desiredresults, PEGs will look to harvest theirinvestment and ensure that they achieve theappropriate returns on the investment. To doso, the PEG will “take the business to mar-ket” and go through another sales process,similar to the process that brought the PEGto the acquisition in the first place. Again,this will typically occur three to seven yearsafter the initial investment. Rarely do PEGslook to exit earlier than three years, and theywill typically only remain longer than sevenyears if the company is performing quite wellor if the company still needs to achieve cer-tain results to meet the required equityreturns of the PEG.

Next month’s article will explore the top 10misperceptions of buyers and sellers in pri-vate equity transactions.
