private equity and public security issuance gordon phillips robert h. smith school of business...

Private Equity and Public Security Issuance

Gordon Phillips

Robert H. Smith School of BusinessUniversity of Maryland

Presentation based on recent research paperAvailable on my web site

The Eras of Private Equity

2

(1) Excludes deals less than $400MM or greater than $15B(2) Approximate gross IRRs of vintage year deals by selected large funds(3) Calculated as the CAGR between the median beginning half year levels and median of ending half year levels.Source: Morgan Stanley, TPG estimates

1984 - 1988“Drexel Era”

PE Global Deal Volume

• Average / Year $40B

• PE Market Share (1) 14%

Distribution to LPs (Avg/Year)

$0.8B

PE Fundraising (Avg/Year)

$12B

% Equity in Deals (Last Year)

10%

Approximate PE Returnsfrom Selected Large Funds (2)

50%

S&P 500 % CAGR (3) 14%

PE Outperformance 36%


3


1984 - 1988“Drexel Era”

1989 – 1993“Slowdown

Era”


• Average / Year $40B $19B

• PE Market Share (1) 14% 5%


$0.8B $1B


$12B $14B


10% 22%


50% 20%

S&P 500 % CAGR (3) 14% 6%

PE Outperformance 36% 14%


4


1984 - 1988“Drexel Era”


Era”

1994 – 1997“Growth

Era”


• Average / Year $40B $19B $21B

• PE Market Share (1) 14% 5% 2%


$0.8B $1B $8B


$12B $14B $45B


10% 22% 30%


50% 20% 35%

S&P 500 % CAGR (3) 14% 6% 22%

PE Outperformance 36% 14% 13%


5


1984 - 1988“Drexel Era”


Era”

1994 – 1997“Growth

Era”

1998 – 2001“Survival

Era”


• Average / Year $40B $19B $21B $59B

• PE Market Share (1) 14% 5% 2% 3%


$0.8B $1B $8B $20B


$12B $14B $45B $100B


10% 22% 30% 41%


50% 20% 35% 13%

S&P 500 % CAGR (3) 14% 6% 22% 1%

PE Outperformance 36% 14% 13% 12%


6


1984 - 1988“Drexel Era”


Era”

1994 – 1997“Growth

Era”

1998 – 2001“Survival

Era”

2002 - 1H2005

“Golden Era”


• Average / Year $40B $19B $21B $59B $120B

• PE Market Share (1) 14% 5% 2% 3% 11%


$0.8B $1B $8B $20B $44B


$12B $14B $45B $100B $75B


10% 22% 30% 41% 32%


50% 20% 35% 13% 40%

S&P 500 % CAGR (3) 14% 6% 22% 1% 9%

PE Outperformance 36% 14% 13% 12% 31%

Recent Trends

7

The private equity industry has seen tremendous growth recently, with the value of buyouts surging dramatically over the past two years.

LBO Transactions in the U.S. and Europe ($bn)

0

100

200

300

400

500

1999 2000 2001 2002 2003 2004 2005 2006

Source: The Economist

8

The top 10 funds today have raised $8-16 billion each, while two years ago the largest fund was worth “only” $6 billion.

Source: The Economist

Recent Trends

Top 10 Private Equity Funds by Amount Raised(Jan 22nd 2007, $bn)

6 8 10 12 14 16 18

Warburg Pincus Private Equity IX

Providence Equity Partners VI

Fourth Cinven Fund

Goldman Sachs Capital Partners V

Bain Capital IX

Apollo Investments Fund VI

Permira IV

TPG Partners V

Blackstone Capital Partners V

KKR 2006 Fund

2005

2006

2006

2005

2006

2005

2006

2006

2006

2006

Year of most

recent close

9

Strong returns and low volatility have made private equity a key component of institutional asset allocation…

Source: Thomson Financial (excludes venture capital)

Average Returns on Private Equity Funds(Oct 2003 - Sep 2006, % per year)

8 10 12 14 16 18

S&P 500

Mega Funds

Large Funds

Medium Funds

Small Funds

Growth Drivers

10

…unleashing a torrent of capital into the industry.

Source: Thomson Financial (excludes venture capital)

Private Equity Fundraising ($bn)

24.8 29.0

51.2

96.1102.9

2002 2003 2004 2005 2006

Growth Drivers

11

Other factors contributing to the ever increasing deal size include decreasing costs of debt financing…

Source: Goldman Sachs

High yield financing: 5-yr constant maturity yields and spreads to treasury

Growth Drivers

12

Source: Goldman Sachs

The sector breakdown of deals is changing as funds look for new sources of deal flow, with technology and telecom gaining importance.

Changing Deal Landscape

Private Equity Deals By Sector

Consumer

Industrials

Health Care

Tech

Telecom

Energy/ MaterialsReal Estate

Financials

0%10%20%30%40%50%60%70%80%90%

100%

2004 2005 2006

13

Source: TPG

As mega funds target bigger deals, they also find themselves increasingly targeting public companies…


10.6%24.7%

41.2%56.6%

83.1%

89.4%75.3%

58.8%43.4%

16.9%

0%

20%

40%

60%

80%

100%

$100-500MM $500MM-$1B $1-5B $5-20B $20B+

Revenues

% o

f Com

pani

es

Private

Public

What do Private Equity Investors Look At?

14

Business Diligence

Management team Capital structureCompetitive and industry dynamics

Exit strategies

Future strategy Compatibility with other shareholders

Financial forecasts Regulatory and legal implications

Valuation/projected risk adjusted rate of return

Compatibility with other portfolio investments

Valuation Methods Structuring Alternatives

Asset-Based Methods Common EquityComparables Senior/Convertible PreferredFree Cash Flow Methods Earn-Outs / Seller Notes

Sample Letter of Intent

15

An LOI is a formal method of stating a desire to pursue a transaction, without any obligation on the part of the buyer, while outlining basic terms.

Purchased Assets

Assumed Liabilities

Purchase Price

Pre-Closing Covenants

Conditions to Obligation

Due Diligence

Confidentiality; Non-Competition; Exclusivity

Employees of the Business

Public Announcements

Expenses

Indemnification

Sample Due Diligence Checklist

16

Detailed diligence leading to the drafting and signing of a purchase agreement is accomplished by the private equity firm along with accountants, lawyers and other advisors. Organization of the Company

Ownership and Control of the Company

Assets and Operations / Quality of Earnings

Intellectual Property

Reporting

Compliance with Laws

Environmental Matters

Litigation

Significant Contracts and Commitments

Employees, Benefits and Contracts

Tax Matters

Sample Term Sheet

17

When partnering with management or current owners, or when pursuing a transaction in partnership with others, the term sheet is an “agreement to agree” on the main points of a deal.Binding Provisions

Confidentiality

“No Shop” Provision

Basic Provisions

Type and Price of Security; Valuation; Capitalization

Earnouts

Dividends

Liquidation Preferences

Conversion Provisions

Voting Rights and Protective Provisions

Board of Directors; Information Rights

Redemption

Antidilution Provisions

Transfer Restrictions; Preemptive Rights; Rights of First Refusal; Tag-Along and Drag-Along Provisions

Registration RightsSource: Andrews Kurth LLP

Monitoring and Investment Management

18

Serve as consultant to portfolio companies

Review plans for enhancing profitability

Help assess the feasibility and means of achieving certain strategic and financial objectives

Assist the portfolio companies in several additional areas:

Strategic direction

Growth, both organic and through acquisition

Review of market position and marketing plans

Industry and customer contacts and introductions

Profit plans and performance reviews

Performance appraisals of management

Major capital spending plans

Capital structure alternatives

While management of each portfolio company is responsible for day-to-day operations, the private equity firm sits on the Board and can take an active role in monitoring and guiding business and financial conditions.

Presentation by Gordon PhillipsJune 2007

Private and Public Security Issues

Which Types of Firms Issue Privately?

Questions of Interest

What markets do firms issue securities in?

What factors impact the choice of market where firms raise capital?

What types of securities do firms issue?

What factors impact what types of securities they issue?



Case Study 1GOOGLE Public Seasoned Equity Offering

On Aug 17th, 2005 (after close of stock market) Google announced it would sell 14.1 million shares in the stock market. Price at close of day on Google was $285.10.

This offer would raise over 4 Billion in cash for the company at current stock price.

This compares to the 1.161 Billion (net) it raised at its IPO on Aug. 19, 2004. ( 14.1 million shares sold by company at the time of the IPO, 8 million by other investors.)

Google’s situation at that time: Had 2.9 Billion in cash end of June, 2005. Increased from 1.3 Billion from end of

June, 2004. Net income in previous 6 months was 918 million on sales of 2,641 million =

34.8% operating margin. Paid taxes of 239 million. In past year Google went up over 300% from its IPO price of $85.

Stock price reaction after the SEO was announced?

-$5.11 or -1.8%



Case Study 2Interwave Communications (IWAV) Private Placement

On Nov.13th 2003, Interwave Communications announced it would sell 1.350 million shares in the stock market in a private placement. (PIPE offering).

Existing shares of stock: 6,872,542 shares. Dilution therefore was 17.7%. Stock was offered at a discount of 17.7% versus the previous closing price. Gross offer proceeds was $5,299,965

Cash Position: Began 2002 with 46.8 million in cash. Ended 2003 with 4.4 million in cash.

Firm’s operating cash flow for 2002 was -37 million, in 2003 – 19 million

(sales were 29.9 million in 2003.)

Stock price reaction on the day of the PIPE?

+15.14%



Some Recent Private Placements

Sun Computers sold $750 million convertible bond issues to KKR. Stock price response +12%.

Palm Inc. sold 25% Private Equity stake to Elevation Partners: +9% Stock Price return.

Presentation by Prof. Gordon Phillips

Year Public Public Public Private Private PrivateDebt Convertibles Equity Debt Convertibles Debt Convertibles Equity Total

1995-'03 N 1,820 201 1,642 1,017 597 5,609 1,156 1,377 13,419$MM 636,245 72,357 163,762 320,968 159,477 1,493,159 30,686 25,601 2,902,255%FV 7% 14% 22% 27% 17% 33% 15% 15% 23%

%FV (med) 3% 9% 15% 16% 13% 22% 9% 9% 13%

Table 1Number and Gross Proceeds of Securities

144-A

Private markets are important for public firms.

62% of convertibles and equity issues are issued in private markets (57.8% without 144A mkt.)

Some Striking Simple (New) Facts


Security Issuance by Size of Firm

Table 2Security Issuance by Size Quartiles

Size Quartiles (by lagged assets) Public 144-A PrivateDebt Convertibles Equity Debt Convertibles Debt Convertibles Equity

Smallest Firms (1st quartile)Number of issues 11 18 564 51 44 938 784 945% of issues of security type 0.60% 8.96% 34.35% 5.01% 7.37% 16.72% 67.82% 68.63%% of issues of total issues 0.08% 0.13% 4.20% 0.38% 0.33% 6.99% 5.84% 7.04%% Issues Private /(Public + Private in size quartile) 98.84% 97.76% 62.62%

Largest Firms (4th quartile)Number of issues 1,472 91 135 343 176 1,079 23 35% of issues of security type 80.88% 45.27% 8.22% 33.73% 29.48% 19.24% 1.99% 2.54%% of issues of total issues 10.97% 0.68% 1.01% 2.56% 1.31% 8.04% 0.17% 0.26%% Issues Private /(Public + Private in size quartile) 42.30% 20.18% 20.59%

Total Issues 1,820 201 1,642 1,017 597 5,609 1,156 1,377

For firms in lowest size quartile of issuing firms, 81% of convertibles and equity issues are issued in private markets

Private Placements: The Regulations Securities cannot be issued unless they are

Registered (i.e. the company files a registration statement with the SEC that is declared effective)

Or there is a statutory exemption for the sale securities not registered are restricted securities

Statutory exemptions for restricted securities Private placements are generally conducted in accordance with the

“safe harbor” provisions of Regulation D of the 1933 Securities Act Basically there can be no more than 35 non-accredited investors and an

unlimited number of accredited investors Restricted securities cannot be resold or traded in the public markets

(exchange) before they registered with the SEC – typically 3 months to a year (Rule 144)

They may however be traded privately to qualified institutional buyers (QIB) at any time under Rule 144A.

Firm can disclose “material, non-public information” to investors. This exemption remains under Reg. FD.


Questions & Motivation

Goal is to explain the surprising finding that public firms are frequent issuers of private securities.

The Usual Suspects: Our question: How do

asymmetric information (pecking-order from adverse selection problems), moral hazard problems, taxes and profitability (trade-off theory) impact choice of security and market?

Ideal environment to examine these key problems as we can condition on security type and examine choice of market and vice-versa


Major Findings – Large Differences in Markets

1. Asymmetric Information

“Usual suspect” but “Unusual and new results” Firms probability of issuing in the private market

increases with asymmetric information for all security types.

Firms with likelihood of issuing private equity and convertibles increases with measures of asymmetric information.


Major New Findings – 2 Market timing

Again large differences between public and private mkts.

2. We find market timing in public but not private equity markets.

Firms are relatively more likely to issue equity in the public market after their stock has risen. They also time security issues closer to earnings reports in public markets.


We show that smaller firms with high risk & high asymmetric information are particularly more likely to issue private equity and convertibles.

The Data Securities issued from 1995:1 to 2003:12 by publicly

traded corporations Private issues:

Common stock + convertible bonds + convertible preferred stock + 144-A convertible issues from PlacementTracker database

Private bank debt (revolving credit + term loans): DealScan database

Public issues: SDC new issue databaseData linked to IBES and COMPUSTAT/ CRSP

In CRSP and Compustat (for one year before issue) excluding financials (6000-6999) and regulated utilities (4900-

4999) 6 databases linked + corporate governance

measures.


Characteristics of Private and Public Stock Offerings

Public SEOs PIPE issues

Offering Discount

Average 5.6% 11.6%

Median 5.4% 12.1%

Maximum 20.0% 70.2%

Issue Size relative to existing f loatation (Dilution)

Average 18.7% 21.2%

Median 12.7% 13.1%

Maximum 600.0% 1260.0%

Firm Size (Market Capitalization)

Average 1331.2M 268.3M

Median 364.0M 73.4 M


How does the Market Respond to Security Issuance Decisions?

Given the discount, does the market react unfavorably, and more unfavorably to private deals?

Given that these companies are all publicly traded, we can measure the stock price reaction to these issue decisions – on existing stock already trading.

We examine the reaction net of the overall market reaction for different windows of time.


-3.09% -2.90%

2.75%

0.33%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

Average Excess Reaction Median Excess Reaction

Stock Price Market Reaction to "Typical" DealExcess Returns (Days -1 to +1)Source: CRSP; Sagient Research Systems; Thomson Financial

Public SEOs (1369 deals)

PIPE Issues (2008 deals)


-4.26%-3.88%

0.91%

5.14%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%






-4.64% -4.95%

1.05%

6.77%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%






Excess Return Distribution (Days -10 to +10)Source: CRSP; Sagient Research Systems

0

50

100

150

200

250

300

350

-1 --0.9

-0.9- -0.8

-0.8- -0.7

-0.7- -0.6

-0.6- -0.5

-0.5- -0.4

-0.4- -0.3

-0.3- -0.2

-0.2- -0.1

-0.1- 0

0 -0.1

0.1-

0.2

0.2-

0.3

0.3-

0.4

0.4-

0.5

0.5-

0.6

0.6-

0.7

0.7-

0.8

0.8-

0.9

0.9- 1

1 -1.1

1.1-

1.2

1.2-

1.3

1.3-

1.4

1.4-

1.5

1.5-

1.6

1.6-

1.7

1.7-

1.8

1.8-

1.9

1.9- 2

Note: Five companies had a (-10,+10) announcement return of less than -100%. Two companies had a (-10,+10) announcement return greater than 200%.

Excess Return (%)

-100 -80 -60 -40 -20 0 20 40 60 80 100 120 140 160 180 200

Frequency


Regression Coefficient Estimates

Prediction of 10 Day AnnouncementExcess Returns (-10 to +10)

Robust Regression Results

Variable

PIPE Indicator 0.062 a

Dilution 0.029 a

Discount -0.012

Discount x Dilution -0.025

log (Market Capitalization) 0.008 b

Constant -0.089 a

Number of Deals 2728

a, (b): significant at the one (five) percent significance level.


Extensions to the Basic Model

Look at all security types.

Examine impact of:

“Analyst uncertainty” / asymmetric information

Taxes

Profitability

Financial Distress


Why do firms Issue different securities?

Important Variables• Measures of asymmetric information:

– Analyst earnings surprise:

Abs(actual earnings – median(estimate)) – Dispersion (sd) of analyst estimates.

• Risk: sd of quarterly cash flow• Trade-off variables: Marginal tax rate,

profitability and financial distress indicator• Market timing: Pre-Issue cumulative abnormal

stock price return.


Asymmetric InformationAverage Analyst Earnings Surprise

[Abs(actual earnings-estimate)]

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

PublicDebt

PrivateDebt

PublicConvert.

PrivateConvert.

PublicEquity

PrivateEquity

Security Type

Analyst Earnings Estimate Dispersion(averages over all firms)

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

PublicDebt

PrivateDebt

PublicConvert.

PrivateConvert.

PublicEquity

PrivateEquity

Security Type


Profitability (OCF/laggged assets)

-30.0%

-25.0%

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

PublicDebt

PrivateDebt

PublicConvert.

PrivateConvert.

PublicEquity

PrivateEquity


Marginal Tax Rate

0.0%5.0%

10.0%15.0%20.0%25.0%30.0%

PublicDebt

PrivateDebt

PublicConvert.

PrivateConvert.

PublicEquity

PrivateEquity

Security Type


Average Pre-Issue Cumulative Abnormal Stock Return

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

90.0%

PublicDebt

PrivateDebt

PublicConvert.

PrivateConvert.

PublicEquity

PrivateEquity

Security Type


Models Adding Market ChoiceNested Logit

Market First, Security Second

eprivee

cprivcc

dprivd

xbxbV

xbxbV

xbV

EEE

CCC

DD

xbV

xbV

V

privprivpriv xbV

private public

Debt

Convertibles

Equity

publicpublicV


• Figure 1: Graph shows the predicted security issuance with the maximum probability for each of 3 size terciles – as risk and asymmetric information are varied.


Conclusions The stock market reacts positively to private equity and negatively to public

equity issues – despite private equity issues being sold at a much higher discount.

Conditional on issuing in the public market, firms are more likely to issue public debt (and less likely to issue public equity) when:

Analysts disagree more about the company’s future earnings (there is high asymmetric information about the company’s future). Consistent with a “Pecking Order in the Public Security Markets”

More likely to issue equity when stock price has risen recently – Market timing i.e. Google..

Firms are more likely to issue private securities and in particular private equity (verses public securities and debt) when:

Analysts disagree more about the company’s future earnings (there is high asymmetric information about the company’s future). (OPPOSITE of public markets.)

Firms are unprofitable and have indications of financial distress


Subsequent Issues

• 13,419 issues.

• 8,382 represent a second (or third) issue by a firm.


Subsequent Issues

Table shows Number of issues (first row), median percentage change in analyst

surprise (2nd row) & median percentage change in analyst dispersion (3rd row).

Subsequent IssuePublic Public Public Private Private Private TotalDebt Conv. Equity Debt Conv. Equity

First Public 943 72 94 524 16 9 1,658Issue Debt -0.01 -0.11 0.02 0.08 0.89 0.12 0.02

0 0.04 -0.02 0.05 0.08 0.2 0

Public 60 64 31 145 5 12 317Conv. 0.05 0.17 -0.28 -0.04 0.96 0.54 0.03

-0.03 0.01 -0.16 -0.08 0.83 0.04 -0.04

Public 98 101 145 390 46 39 819Equity -0.2 -0.17 -0.08 -0.03 0.24 -0.05 -0.08

-0.06 -0.09 -0.23 -0.07 0.17 0.22 -0.08


Subsequent Issues - 2

Table shows Number of issues (first row), median percentage change in analyst surprise (2nd row) & median percentage change in analyst dispersion (3rd row).

Subsequent IssuePublic Public Public Private Private Private TotalDebt Conv. Equity Debt Conv. Equity

First Private 606 155 312 1,571 108 122 2,874Issue Debt 0.03 0.14 -0.1 0.07 0.46 0.68 0.05

0 0 -0.07 0.12 0.43 0.55 0.05

Private 15 14 32 98 265 139 563Conv. -0.18 0 -0.22 0.17 0.41 0.68 0.3

0.01 1.48 -0.02 0 0.13 0.25 0.11

Private 7 19 60 108 116 336 646Equity 0.21 -0.05 -0.06 0.25 0.08 0.11 0.09

-0.1 -0.03 -0.15 0.24 0.14 0.04 0.05

Totals 1,729 425 674 2,836 556 657 6,877-0.01 0.02 -0.08 0.05 0.3 0.32 0.03

0 0 -0.08 0.04 0.28 0.16 0.01


Latest Conclusions

• Public issues are more likely to continue to issue publicly.

• Private issuers do “graduate” back to public issues.

• If you graduate, for case of private equity, the subsequent public equity issue is 5.74x (mean, 3.05x median) greater than your PIPE & is associated with decreases in measures of asymmetric information.

Global Public to Private Transactions

$-

$50

$100

$150

$200

$250

$300

$350

$400

84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 1H05 Last

Vol

ume ($

bn)

18 Months

53

Source: TPG

… resulting in a dramatic increase in “public to private” transactions.


More public-to-private transactions in the last 18 months than in the

prior 18 years

In Summary

54

2H05 - ?“New Era”


• Average / Year ?

• PE Market Share ?


?


?


?

Approximate PE Returnsfrom Selected Large Funds

?

S&P 500 % CAGR ?

PE Outperformance ?

Dramatic Growth

Increasing deal volume

Larger deal size

Bigger funds

Driven by:

Large inflow of capital

Lower cost of debt

Increasing deal leverage

Trend towards club deals

Resulting in:

Changing sector focus

More public-to-private transactions

Changes in public perception

private equity and public security issuance gordon phillips robert h. smith school of business...

Documents

b pe fundraising avgyear

b pe market share

pe outperformance36

approximate pe returns

selected large funds

eras of private equity

lps avgyear

morgan stanley