how private equity really works p1
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Feature Article
32 Imaging Spectrum August 2007 International Imaging Technology Council www.i-itc.org
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International Imaging Technology Counci
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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 company
is acquired using a combination of debt and equity,totaled
just under $60 billion of transactions in 2002. In 2006,
LBOs accounted for more than $400 billion of transactions. In the
first half of 2007, there have been over $335 billion of LBO trans-
actions. Looking forward to 2008 and beyond, one might assume
that the volume of LBO activity will only increase. However,LBOs
are cyclical and the current cycle, the biggest ever, is bound to
come 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 or
yesterday, savvy business executives are well-served knowing more
about the mechanics of private equity firms and how a leveraged
buyout works. Several private equity groups (PEGs) have made
forays into the compatible imaging supplies industry in recent years
(Hyde Park Holdings, Key Capital Partners, Stonehenge Capital,Kayne Anderson and Blackford Capital, among others), several
more have investigated the industry and, no doubt, a few more will
still 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 the
process of a transaction and articulate the philosophy or point of
view 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 when
acquiring public entities) or other public disclosure regulations.
Interestingly, two of the largest private equity firms (Blackstone
and KKR) have recently completed or announced initial public
offerings. As its name also implies, private equity typically involves
equity (not debt) investments. However many, if not most, private
equity 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 leveraged
buyouts, seed investments, venture capital, angel investing, growth
capital and other various forms of financing or investing.
Private equity can be categorized by the size of investment, type of
investment, target rate of return, investment horizon,source of cap-
ital, number of investments per year and location within the capital
structure, among other factors. There are approximately 1,000 to
2,000 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 capital
from 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 firms
acquire existing businesses with a combination of debt and equity
and work aggressively to improve the value of the companies they
acquire 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 London
School of Economics.
Tony Kiehn is a managing director at Blackford Capital. Kiehn led Blackford Capitals sale of Rhinotek to Reliant
Equity Investors.Kiehn has 10 years of experience working in Asia.He is a graduate of Harvard Business School and theUniversity of Nebraska.
Martin Stein is the managing director ofBlackford Capital,a private equity firm focused on middle-mar-
ket acquisitions,and ser ves 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.
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Private Equity is Bigand Growing Even Bigger
As Chart 1: Private Equity Invested reveals, the private equity indu
try grew from $1 billion of equity invested in 1993 to approximat
$15 billion in 2000 and was fueled, in large part, by the ventu
capital community. From 2001 to 2007,equity investments grew fro
$8.5 billion to $85 billion,fueled almost entirely by leveraged buyou
Chart 2: The Biggest LBOs of All Time provides a dramatic demo
stration of the recent rise of LBO transactions. The numbers a
quite impressive.As of July 3, five of the biggest LBOs have been
2007, four were in 2006, and one is the historic KKR deal immort
ized in the legendary business book, Barbarians at the Gate. Ar
cles in leading publications also point to the hot industry mark(see sidebar,Private Equity Makes Headlines).
Even more compelling is the data on Chart 3:Available Private Equ
ty Capital. The total amount of uninvested capital has increas
from $35 billion in 1990 to $180 billion today. Uninvested capital
used to denote the amount of available funds targeted to be inve
edthis number effectively represents the available capacity f
transactions. Uninvested capital is a trailing figure (note the low
level is in 2004, several years after the industry peak), but it is hig
ly meaningful because it sets the stage for coming years. From 19
to 1995, the amount of uninvested capital grew from $35 billion
$40 billion,approximately 3 percent per year. From 1995 to 2007, tamount of uninvested capital grew from $40 billion to $180 billio
approximately 70 percent per year.
How Private Equity Works
Private equity firms (both LBO and venture capital) are responsible fo
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 Groups initial public
offering was the largest IPO in the past five years and,arguab ly,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,hotGlobe and Mail,6/22/07
US M&A Hits $1 Trillion in Record PaceFinancial News Online US,UK,6/28/07
Private Equity M&A In US Accounts For 35% Of Overall Activity,Up From 16%
A Year AgoThompson Financial,5/22/07
The 2000s M&A Boom Has ArrivedWall 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 Exit s SlowWall Street Journal,
7/14/06
Private Equity Buyers Are Creeping Into Non-Private Equity Sectors Such As
Financials,Energy and Power, High Tech,and TelecomThompson Financial,
5/22/07
Blackstone Buyout Fund Hits Industry High $15.6 BillionWall Street Journal,
7/12/06
Attracting Private Equity Becomes A National Spor t In EuropeNew York
Times,6/29/07
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Each of these activities involves a very distinct set of skills and capa-
bilities and will often have different team members involved.
Sourcing Transactions
There are between 4,000 and 8,000 middle market merger and
acquistion (M&A) transactions completed per year in the United
States. There are many more acquisitions by individual buyers. The
middle market typically refers to transactions ranging from $10
million to $500 million. Most middle market transactions are notcompleted, so there are roughly 10,000 to 20,000 deals brought to
market each year. As Chart 4: Total Number of US M&A Transac-
tions Completed Each Year indicates, several hundred of these deals
exceed $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 referred
to as lower middle market. Additionally, an even larger number of
acquisitions are never recorded because they occur between indi-
viduals or are unannounced. Private equity firms are responsible
for roughly 20 percent of the transactions, while corporate buyers
account or the remaining 80 percent.
Chart 5: Sourcing TransactionsThe Deal Pipeline provides detail
on the number of transactions a private equity firm will investigate
to 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 3,000
deals per year (roughly one-quarter to one-half of the total deals
brought to market, if the PEG is in touch with the right intermedi-
aries such as bankers, accountants, and lawyers). Of those, between
5 percent and 10 percent (some 50 to 300) actually meet the firms
criteria. 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 smallerthere are only so
many $500+ million deals per year.
Once a private equity firm has determined that the deal fits its crit
ria (size, industry, growth, earnings, management team, etc.) an
more importantly, they believe the company has the potential
increase in value,the PEG will schedule a meeting with the manag
ment team to get additional information. PEGs may schedule mee
ings with between 5 percent and 50 percent of the firms that me
their initial criteria, depending upon how strict their criteria a
These meetings can be short or long, but in order to be productithey almost always involve the exchange of financial information
After a preliminary meeting, the PEG will evaluate the business, t
industry, the management team, and the opportunity to increa
the value of the business. If the PEG believes there is an opportun
ty to increase the value of the company and the shareholders hav
reasonable expectation of value, the PEG will submit a Letter
Intent (LOI) based upon the feedback or direction from t
shareholders (see sidebar,Interpreting an LOI). Typically, an L
is a serious indication of a desire to move forward on the part of t
private equity firm. Once an LOI is signedmost are non-bin
ingthe shareholders of the firm and the PEG will work throu
additional due diligence needs over a 60- to 120-day period to co
summate the transaction.
Due Diligence/Completing Transactions
Chart 6: A Typical Due Diligence Process for a Private Equity Fir
delineates the seven mission-critical steps a PEG will need to compl
during due diligence to consummate a transaction.From start to clo
a well-managed transaction should take approximately 16 weeks. P
vate equity firms may take four weeks to present an LOI (although th
process can certainly take longer) and then 12 weeks (approximate
75 to 90 days) following the signing of a LOI to complete a transactioThe schedule in Chart 6 assumes that the entire process (including in
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 groups (PEGs) desire to
acquire or make an investment in a particular company.
LOIs are based on the information made available to t he
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 DealWhat is the value of the entity?
How is it being valued?
Structure of the TransactionHow will the deal be
structured? Cash at close? Payments over time?
Terms of the DealWhat assets are being acquire
(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?
TimelineWhen is the transaction expected to
close?
Conditions to CloseWhat activities need to be
completed in order to close the transaction? Are the
any particular activities that would prevent a transa
tion from being closed? Must the business meet a
certain performance requirement?
Due Diligence ProcessWhat will occur during t
due diligence process? Will employees, customers a
suppliers be contacted? Will there be an environme
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Immediately following the signing of the LOI, the PEG will begin
to complete the financial model/operational plan for the business.
This process requires involvement by the companys management
team and, potentially, its shareholders (frequently the same peo-ple in small enterprises). In this process, PEGs are looking to test
their initial hypotheses about the potential future financial per-
formance of the business.PEGs will invest a significant amount of
time in the financial analysis of the business, testing questions
such as:
RevenuesHow many current customers are there? What
have 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-CompeteIf 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.
ConfidentialityOften,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.
ExclusivityPEGs 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,wh
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 t
get negotiated,it often signals an unwillingness on the p
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 partic
larly meaningful if both parties have not fully explored an
discussed all of the components of the LOI.
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be in the future? What are the sources of revenue? How is the
product/service mix changing?
Cost of Good SoldWhat is the cost structure for the busi-
ness? How volatile are the costs? Will costs increase or
decrease? 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 ExpensesWhat functions do the various man-
agement team members serve? How much are they paid for
these functions? What is the structure of the sales team? How
much advertising is required? Will additional investments
yield increased results?
Many PEGs will test the hypotheses for the business with rigorous
analysis involving customers, vendors, employees and outside
industry analysts. Typically,PEGs will require a substantial amount
of data to complete their analysis. The company will need to be
intimately involved in providing this information, and most PEGs
(or buyers, for that matter), will not engage outside service
providers until they have received, processed, and digested the
information presented to them. This completes roughly the first
third of the transaction.
The second third of the transaction involves the outside service
providers, such as accountants, lawyers, and other miscellaneous
consultants. PEGs will select the number of outside consultants
based upon the size of the transaction,the risk factors identified, the
financial 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. General
the outside consultants, lawyers and accountants are confirming t
information that has been presented.All parties (buyers and seller
want to ensure that there are no surprises.
The final third of the transaction is financing and documentatio
In most LBOs, PEGs will use debt both to satisfy the purchase pri
requirements of the seller and to increase their returns. Typicalsellers prefer a higher price than what equity returns alone wou
justify. As a result, buyers are forced to finance a transaction w
debt. Similarly, buyers have certain thresholds for returns th
require them to use debt to finance a transaction. If a buyer pu
chased a business entirely with equity, the performance of the bu
ness would need to be incredibly high in order for the buyer
achieve the necessary returns.
Bank financing is not a complex process for a good business and
good private equity firm. Banks will provide debt based on asse
and cash flows. Businesses with poor cash flows (low profitabilit
or limited assets will have difficulty getting financed. Additional
businesses with less than $2 million of earnings before intere
taxes, depreciation and amortization (EBITDA) have difficulty ge
ting financed because they are perceived as quite risky businesse
Larger deals are much easier to get done. Banks can take three
eight weeks to complete their own due diligence and agree
financing commitments.
The documentation process involves the drafting, editing and sig
ing of the asset or stock purchase agreement. The terms of the AP
should roughly mirror the terms of the Letter of Intent. Howev
oftentimes during the due diligence process, buyers will identfinancial costs, litigation, or other risk factors not previously d
closed that require an adjustment in the price and/or structure
the transaction.
For example, the owner may have suggested that the financial sy
tem would need to be upgraded prior to the signing of the LOI,b
he did not inform the buyer that the system was a $100 off-th
shelf product that froze multiple times a day, did not perm
monthly closings, and/or have a general ledger that was off
approximately $1 million, a material amount. Alternatively, t
seller may have informed the buyer that the inventory was valu
accurately, yet the buyer identified $2 million worth of non-virginkjet cores that were completely unusable and would need to
written off. Neither of these factors should be deal killers. Howe
er, they do represent material findings that could negatively imp
the value of the entity being acquired.
In addition to an asset purchase agreement, documentation m
also,but does not necessarily, involve the following legal documen
Employment Agreementsa potential agreement with the
chief principals remaining after the transaction that governs
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the relationship post transaction
between the acquirer and the principal.
Non-compete Agreementa poten-
tial agreement that determines the
length of time, after exiting the firm,
that principals will not work in direct
or indirect competition with the busi-ness they sold.
Disclosure Schedulespotential
documentation that supports the asset
purchase agreement and provides
details about the business. Schedules
provide representation on inventory,
accounts receivable, litigation and
many other facets of the business.
Loan DocumentsIf debt is used in
the transaction, there will be loan doc-
uments that detail the loan provisions,
covenants, terms, price and other vari-
ables associated with the loan.
Miscellaneous AgreementsThere
are other specific documents that may
be required for both buyers and sellers
to complete, including shareholder
consents, board approval of the trans-
action, and assignment and assump-
tion documents.
Ensuring the Success
of Portfolio Companies
A typical private equity firm will manage
between three and 40 portfolio companies
at one time. Some larger, well-established
funds could potentially have more portfolio
companies, and select smaller funds with a
more limited focus or a firm that was exit-
ing its investments could manage fewer
portfolio companies.
Typically, private equity firms hold posi-
tions on the boards of their portfolio
companies with quarterly in-person
meetings. At the early stages of an invest-
ment, PEGs may look for weekly results
reports and performance reviews.Assum-
ing a portfolio company is doing well,
PEGs will become less involved as the
management team achieves the targeted
results. PEGs are responsible for ensuring
that management is successful, but they
are not necessarily responsible for manag-
ing the business itself. If management is
not doing well, PEGs may be required to
find new management for a business.
Given that PEGs look at an investment for a
three- to seven-year horizon, with a usualtarget of five years, one year of missed
results translates into a 20 percent setback
(one year divided by five years) on the life
of the investment. Every quarter represents
5 percent of the investment horizon. There-
fore,a PEG is not likely to let more than sev-
eral quarters of missed results transpire
before needing to seriously evaluate the
management team.
Exiting the Investment
After a company has achieved its desired
results, PEGs will look to harvest their
investment and ensure that they achieve the
appropriate returns on the investment.To do
so, the PEG will take the business to mar-
ket and go through another sales process,
similar to the process that brought the PEG
to the acquisition in the first place. Again,
this will typically occur three to seven years
after the initial investment. Rarely do PEGs
look to exit earlier than three years, and they
will typically only remain longer than sevenyears if the company is performing quite well
or if the company still needs to achieve cer-
tain results to meet the required equity
returns of the PEG.
Next months article will explore the top 10
misperceptions of buyers and sellers in pri-
vate equity transactions.