introduction to private equity (2008)
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Introduction to private equity, presented by James Clarke at the University of Kansas, 2008TRANSCRIPT
Private Equity Club
October 9, 2008
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Introduction to Private Equity
James G. ClarkeDirector
Private Equity Investments
Kauffman Foundation
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• Who am I?• What is private equity?
• Buyouts and venture
• Market overview
• Career options
• Q&A
Agenda
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Who am I?
• Director, Private Equity Investments, Kauffman Foundation (2002 – present)
– >$700 million in private equity fund investments in the U.S., Europe, and Asia
• Founder, Rockhill Partners (2005- present)
– Angel investor in technology and life science companies
• Investment banker with Nations Media Partners (1998 – 2002)
• Co-founder, S&S Communications (1999-2002)
• MBA from the University of Kansas (2004) • BA from Washburn University (1997)
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• Who am I?
• What is private equity?• Buyouts and venture
• Market overview
• Career options
• Q&A
Agenda
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Definition
Private Equity: Private equities are equity securities of unlisted companies. Private equities are illiquid and usually long-term investments. Private equity investments are not subject to the same regulations as securities sold to the general public. Private equity includes two broad classes:
Buyouts involve the purchase of an existing company using a combination of debt and equity. Returns are primarily a function of purchasing cheaply/dearly, growing and/or improving the company, the use of leverage and selling cheaply/dearly.
Venture capital involves making an equity investment in an immature company in the expectation that the company can grow quickly. Returns are primarily a function of its growth rate, size of its market and the exit environment.
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Private equity landscape
Source: Credit Agricole, see slide 41 for additional details
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Private equity backed companies
• Venture Capital
• Buyouts
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A (really) brief history of private equity
• American Research and Development – Founded by Georges Doriot, the “father of venture capital”– $70,000 invested in 1957 in Digital Equipment Corporation (DEC) returned
$355 million after the company's initial public offering in 1968
• J.H. Whitney was formed in 1946 by the Whitney Family– One time investment of $5 million (about $54 million today) – Model followed by several other prominent East Coast families including the
• Whitney accepted outside capital beginning in 1990
• Bessemer accepted outside investors for the first time in 2007– >25 IPOs and >50 M&A exits within the past decade
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Why invest in private equity?
Source: Cambridge Associates, Q1 2008
11.6%
32.8%
23.2% 24.1%
7.1%
11.6%14.1% 13.1%
11.2%
2.8%
7.6%
4.4%
-13.1%
5.5%
10.3%
3.8%
-16.2%
5.7%3.9%4.1%
-20.0%
-10.0%
0.0%
10.0%
20.0%
30.0%
40.0%
1 Year 3 Years 5 Years 10 Years
Venture Buyouts S&P 500 Russell 2000 Lehman Agg.
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Fund structure and organization
Source: EVCA
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The players
• General partner (GP) raises, manages and invests the fund – Typically 4-5 years to invest– Returns capital within 10 years– Put up 1% to 5% of the fund’s capital
• Limited partners (LPs) provide >95% of the capital
• GP takes 2% to 2.5% of the fund’s capital base annuallyannually as its management fee
• GP earns 20%+ of the fund’s profits; the “carried interest”
• Capital is called as needed, not funded all at once
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Private equity is different
• Really expensive 1
• Fat tailed distribution 2
• Persistence of returns 3
• Leverage, Leverage, Leverage 4
• A lot of “smart” investors aren’t very good at it 5
1 – Andrew Metrick and Ayako Yasuda, “The Economics of Private Equity Funds,” 2007
2 – “U.S. Venture Capital Investing,” Cambridge Associates, 2006.
3 – Steve Kaplan and Antoinette Schoar, “Private Equity Performance: Returns, Persistence and Capital Flows,” 2003
4 – See David F. Swensen, Pioneering Portfolio Management, pages 230-234
5 – Josh Lerner, et al, “Smart Institutions, Foolish Choices?: The Limited Partner Performance Puzzle,” 2005
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• Who am I?
• What is private equity?
• Buyouts and venture• Market overview
• Career options
• Q&A
Agenda
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How do buyouts make money?
• Buy.
• Lever.
• Improve.
• Exit.
When in doubt, lever it up!• Responsible for 41% of buyout returns between 1986 and 1990
• Fell to 24% in 1996 to 2000 study
• Biggest factor between 2003 and 2007
Operational Improvements• 34% of return between 1986 and 1990
• 43% of return between 1996 and 2000
Source: Jin Li and Fiona Wang, “Leveraged Buyouts: Inception, Evolution, and Future Trends” Perspectives, Vol 3, No. 6 (Sept. 30, 2002).
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Simple LBO example
• LBO’s are just like buying a house– Minimal down payment (20% to 30%)– Significant leverage / debt (70% to 80%)– Cash flow (your wages / company earnings) must meet debt
payments– Asset (house / company) should increase in value during holding
period (home improvements / company is more profitable)– Minimal initial investment can yield significant gain…especially in
an up market
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Simple LBO example (cont’d)
• Buy a house / company for $100
– Minimal down payment ($20)
– Significant leverage / debt ($80)
– Cash flow (your wages / company earnings) must meet debt payments
– Over three years mortgage / debt payments reduce principal to $75
– Over 3 years value of the house / company rises to $125
– Sell company for $125
– Subtract $75 of debt
– $50 remaining -- $30 gross profit plus $20 originally invested
– 80% of profit to LPs -- $24
– 20% of profit to the GP -- $6
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Leverage!
• Buying house with leverage– $20 invested to buy $100 house, sold for $125 in 3 years– $24 net profit to LPs (on $20 invested)– 33% net IRR, 2.2x multiple
• Buying the house without leverage – $100 invested to buy $100 house, sold for $125 in 3 years– $20 net profit to LPs (on $100 invested) – 10% net IRR, 1.2x multiple
• Interest costs are tax deductible• OPM rule
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Leverage alone is not the answer
Caribbean Restaurants, LLC
1991
Sold 86 stores for $70 million
1994
~5x return
1996
4x return
1999
2.5x return
2004
Paid $340 million for 165
stores, 174 stores today
Sources: All data from public sources including The Lookout from Miradero Capital (Q2 2004) and The Deal, April 18, 2005
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Headed for a fall?
• On March 17, 2008, Standard & Poor's Ratings Services lowered the ratings on Caribbean Restaurants LLC to 'CCC+' from 'B'.
• Definition of CCC: “currently vulnerable and dependent on favorable economic conditions to meet its commitments”
• Highlights of S&P report:– “The outlook remains negative.”– “The downgrade reflects the distinct possibility that the company
will breach financial covenants of its bank facility at its fiscal year-end.”
– “The ratings on CRI reflect its small size in the competitive quick-service restaurant sector, its narrow geographic focus which leaves the company susceptible to changes in the Puerto.”
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Simple venture example
• Venture capital is a little (lot?) like gambling– Identify promising technology– Invest relatively few dollars ($1-$5 million) for 25%+ of the
company)– Work with founders to
• Define strategy
• Improve product/service
• Access key early customers
• Make key hires
– Guide fundraising in additional rounds of capital to fund additional growth and development
– Sell or take company public (IPO)
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• Who am I?
• What is private equity?
• Buyouts and venture
• Market overview• Career options
• Q&A
Agenda
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Market Review
“Never underestimate the power of stupid people in large groups.”
Source: Despair.com
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Ripped from the headlines…
• Texas Pacific Group (TPG) led $7 billion equity infusion in April 2008
• TPG lost about $1.35 billion of its investors’ capital
• 39 buyout-backed bankruptcies YTD…how many more to follow?
WaMu is Seized, Sold Off to J.P. Morgan, In Largest Failure in U.S. Banking History – Friday, September 26, 2008
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Buyouts raised record $’s in 2005, 2006 & 2007
$ in
billio
ns
Source: Dow Jones Private Equity Analyst as of August 2008
$121.1
$228.0
$178.2
$106.4
$57.4
$28.4
$43.1$51.5
$79.6
$43.4
$61.9
$41.5
$19.7$22.5
$0
$50
$100
$150
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
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9 of 10 Largest Deals Ever Occurred in 2005-07
Source: Andrew Ross Sorkin, New York Times Dealbook, February 26, 2007 citing Dealogic data
Deal value,in billions
TXU 2/26/2007Kohlberg Kravis Roberts, Texas Pacific Group, Goldman Sachs 43.8
Equity Office Properties 11/19/2006 Blackstone Group 38.9
HCA 7/24/2006Bain Capital, Kohlberg Kravis Roberts, Merrill Lynch 32.7
RJR Nabisco 10/24/1988 Kohlberg Kravis Roberts 31.1Harrah’s Entertainment 10/2/2006 Apollo Advisors, Texas Pacific Group 27.4Clear Channel Communications 11/16/2006 Bain Capital, Thomas H. Lee Partners 25.7
Kinder Morgan 5/29/2006Goldman Sachs, A.I.G., Carlyle Group, Riverstone Holdings 21.6
Freescale Semiconductor 9/15/2006Blackstone Group, Carlyle Group, Permira, Texas Pacific Group 17.6
Albertson’s 1/22/2006SuperValu, CVS, Cerberus Capital, Kimco Realty 17.4
Hertz 9/12/2005Carlyle Group, Clayton Dubilier & Rice, Merrill Lynch 15.0
Target Date Acquirer
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Money to Burn?
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Too hot?…ratio of capital raised to invested
Source: Venture Economics, U.S. buyouts only
0.0x
1.0x
2.0x
3.0x
4.0x
5.0x
6.0x
7.0x
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
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Déjà vu all over again?
-60
-40
-20
0
20
40
60
80
100
120
140
160
1997 1998 1999 2000 2001
% R
etu
rn
-20
-10
0
10
20
30
40
50
60
70
80
$ B
illio
ns
Avg Tech Fund Return
S&P 500 Return
Sector Fund Cash Flows
Source: Financial Research Corp - 2001 data through Nov. 30.
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Buyout returns likely to disappoint
• Entry multiple 10.0x• Debt multiple 6.5x• Growth rate 5.0%• Exit Multiple 7.0x• Gross IRR 11.5%
Less Fees and Carried Interest
• Net IRR 9.8%
Source: EMKF model, assumes a 5 year holding period, 2% management fee and 20% carried interest
The Dirty Truth:
From 1982 to 2002 buyout funds over $1 billion in size generated an average return of just 5.5%
9.8% could be optimistic!
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Venture fundraising rebounding
$ in
billio
ns
Sources:Dow Jones Private Equity Analyst as of August 2008
$15.0
$32.0
$26.2$22.6
$16.9
$9.2$10.8
$39.4
$72.1
$48.6
$21.0
$14.3
$7.9$6.1
$0
$25
$50
$75
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
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Cleantech investing is hot
Source: Cleantech Group, January 2008
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
2001 2002 2003 2004 2005 2006 2007
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Emerging market fundraising
2007200620042003 2005
2.2 2.8
15.519.4
28.7Emerging Asia ($Bn)
200520042003 2006 2007
0.5 0.82.9 3.3
14.6C. & E. Europe / Russia
($Bn)
20062003 2004 2005 2007
0.40.7
1.3
2.7
4.4Latin America ($Bn)
2003 2004 2005 2006 2007
1.4 1.7 2.7
7.9
11.4Middle East & Africa
($Bn)
Source: EMPEA
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• Who am I?
• What is private equity?
• Buyouts and venture
• Market overview
• Career options• Q&A
Agenda
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A career in private equity?
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Considering a career in private equity?
• Rarely boring• Play with the big dogs• Work with really smart
people• Chance for significant
responsibility early in your career
• Industry expertise or breadth of knowledge across industries
• Chance to make a lot of money
• Hours can be brutal• Big dogs sometimes bite• Smart people aren’t always
so much fun• Hours/days/years spent
doing seemingly menial tasks
• Specialization can lead to obsolescence
• Generalists are a dime a dozen
Pros Cons
• Money doesn’t buy happiness
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Common routes to a job in private equity
• Venture capital– Successful entrepreneurs – Scientists/Physicians (MD, PhD, etc.)– Consultants
• Buyouts– Senior executives and proven operators– Investment bankers
– Consultants • Pedigrees matter
– Ivy league schools, McKinsey and Bain consultants, major Wall Street banks
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Uncommon but common route to private equity
• Hometown: Hesston, Kansas • First job: bailing hay on family farm• Undergrad: BA - Washburn University• First job after college: Accountant -
Pricewaterhouse Coopers• Graduate degree: MBA - Harvard
Business School• First job after MBA: Consultant – Bain
& Co. • Other positions: CEO of PWC
Consulting; President & COO of Continental Airlines; CEO of Burger King; CEO of Quiznos
• Current position: Chairman - CCMP Capital
Q: How did you go from tiny Washburn University in Topeka, Kansas, to Harvard Business School?
A: The reason I got in was because I was from the middle of nowhere, and they were trying to diversify. The first day, we went around the room telling everybody where we were from. I was thinking that if half of what everyone was saying was true, the economy would shut down from an overload of grandiose BS. I had my cowboy boots on at the time, so when it was my turn, I put my boots up on the desk and said, "It's getting pretty deep in here.'' That broke the ice.
Sources: quote from Jungle magazine, May 1, 2001, other information from BusinessWeek (Nov 8, 2004) and CCMP Capital
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Recommended reading and viewing
Private Equity and Venture Capital:• The Venture Capital Cycle, Gompers and Lerner, 2006• Venture Capital and Private Equity Casebook, Lerner et al, 2008 • The Art of the Start, Guy Kawasaki, 2004• Valley Boy: The Education of Tom Perkins, Tom Perkins, 2007• Deals from Hell, Robert Bruner, 2005• Founders at Work, Jessica Livingston, 2007• Anti-Portfolio at www.bvp.com
Institutional Investing: • Pioneering Portfolio Management, David Swensen, 2000• Hedghogging, Barton Biggs, 2006• When Markets Collide, Mohammed El-Erian, 2008
General Investing & Philosophy:• The Millionaire Next Door, Stanley and Danko, 1998• When Genius Failed, Roger Lowenstein, 1998• Ahead of the Curve, Philip Delves Broughton, 2008• Liars Poker, Michael Lewis, 1990• No Asshole Rule, Robert Sutton, 2007
Watch:• Barbarians at the Gate• Pirates of Silicon Valley
The Entrepreneurial Imperative
Carl Schramm, 2006
Good Capitalism, Bad Capitalism
Schramm, et al 2007
A word from our sponsor:
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Questions?
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Appendix
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Private equity landscape
"Angel" "Growth"
Seed 1st Round2nd & 3rd
RoundEmerging
GrowthLeveraged
BuyoutsMezzanine
Debt
Age of Company
0 years 0-1 year 1-3 years 3-10 years 10-50 years 10-50 years
Stage of Company
Idea Prototype1st generation
product
2nd or 3rd generation
product
Established, slow growth
Established, slow growth
Public or Private?
Private Private PrivatePrivate or
PublicPrivate or
PublicPrivate or
Public
Equity Requirement
$0.2-0.5m $1-5m $5-25m $5-100m $10 - 5,000m $10 - 250m
Return Expectations
70%+ 50-70% 50-60% 40-50% 25-40% 20-30%
"Venture Capital" "Buyouts"
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Changing Landscape
Covenant-Lite Volume
Equity Contribution of Leveraged Buyouts
Source: S&P Leveraged Lending Review 2Q08.
Source: S&P Leveraged Lending Review 2Q08.
($ in billions)
Going forward, buyout deals will rationalize with more covenants, higher equity contributions and lower debt ratios.
Source: S&P Leveraged Lending Review 2Q08.
0.0x
1.0x
2.0x
3.0x
4.0x
5.0x
6.0x
7.0x
1999 2000 2001 2002 2003 2004 2005 2006 2007 1H08
All LBO Loans Middle Market LBO Loans
1.8 3.1 0.3 0.3 0.0 0.0 0.5 0.1 2.4
23.6
96.6
0.00.0
20.0
40.0
60.0
80.0
100.0
120.0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 H1'08
30%32%
36%
38%
41% 40% 39%
35%
32%33% 33%
42%
25%27%29%31%33%35%37%39%41%43%
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2H08
Debt/EBITDA Ratios for LBO Loans
Slide adapted from Credit Suisse, October 9, 2008
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5.7x 5.4x4.7x
4.2x 4.1x 4.0x4.6x 4.8x
5.3x 5.4x6.2x
5.1x 4.5x
0.0x1.0x2.0x3.0x4.0x5.0x6.0x7.0x
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Q1 2008 Q2 2008
Both Leverage and Prices Are Dropping Average debt as a multiple of EBITDA
Average price as a multiple of EBITDA
7.9x 8.1x 7.7x6.3x 6.1x 6.5x 7.1x 7.4x 8.2x 8.6x
9.8x 10.0x9.1x
0.0x2.0x4.0x6.0x8.0x
10.0x12.0x
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Q1 2008 Q2 2008
(Price/EBITDA of issuers with EBITDA of more than $50 million)
(TEV/EBITDA of transactions with EBITDA of more than $50 million)
Source:Standard & Poor’s US LBO commentary as of June 30, 2008.
Avg. 4.9x
Avg. 7.8x
Slide adapted from Credit Suisse, October 9, 2008
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Skill-set scorecard
Entrepre-neurship
Finance
Accting
Raw
Genius
Industry
KnowledgeJudgment
Leader-ship
Pedigree;
EducationTeam Player
Capital Markets
Strategy
Consulting
Corporate
Finance
Hedge Funds
General Mgmt
Investment Mgmt
Private Equity
Venture Capital
Credit: Inspired by Scott Stallings, Wharton School, University of Pennsylvania, August 2006 with modifications by the author