privateequity updated 2012 final

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PrivaTE EquiTy dEmysTifiEd: 2012 uPdaTEJohn Gilligan and mike Wright

financinG chanGE iniTiaTivE

Copyright John Gilligan and Mike Wright 2012

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IsBN 978-0-85760-301-2

Financing ChangeAn initiative from the ICAEW Corporate Finance Faculty

This report is part of the Private Equity Demystified series published under Financing Change, the thought leadership programme of the ICAEW Corporate Finance Faculty. The faculty is the worlds largest network of professionals involved in corporate finance and counts accountants, lawyers, bankers, other practitioners and people in business among its members. Financing Change aims to advance the economic and social contribution of corporate finance activity by promoting better understanding and practice.

First published in 2008, Private Equity Demystified An Explanatory Guide appeared at a time when the private equity sector faced considerable public and political scrutiny. Its aim was to enable a better informed debate.

As the major economies moved from growth to recession and the global banking community experienced unprecedented turmoil and distress, the private equity industry saw investee companies striving to cope with economic uncertainty and faced an environment where availability of debt was severely restricted.

Private Equity Demystified An Explanatory Guide, 2nd edition was published in 2010 and examined the way in which the banking market had changed its approach to private equity investments and the dynamics of the restructuring industry. It also included discussion of regulatory proposals such as the European Commissions Alternative Investment Fund Managers Directive and industry efforts to become more transparent to wider stakeholders.

This report, the 2012 Update, is an update of developments in the private equity sector including market trends, regulation and academic research. Private Equity Demystified An Explanatory Guide, 2nd edition should be referred to for:

the analysis of private equity fund structures;

the explanation of risks and rewards of banks and other participants in private equity transactions; and

the detail behind evaluating, structuring and restructuring a private equity investment.

Both reports are available to download from icaew.com/financingchange and hard copies may be obtained by emailing [email protected].

As with previous reports in this series, the 2012 Update provides an objective explanation of private equity. Its value will be measured in better-informed debate, in private equitys effective engagement with wider stakeholders and in well thought out public policies.

We welcome views and other comments on this work and related themes.

For further information on the Financing Change programme please email [email protected] or telephone +44 (0)20 7920 8685.

For information on the ICAEWs work in funding academic research please contact Gillian Knight, Research Manager on +44 (0)20 7920 8478.

PrivaTE EquiTy dEmysTifiEd: 2012 uPdaTEJohn Gilligan and mike Wright

01Private Equity demystified: 2012 update

Page

List of figures and tables 03

Acknowledgements 04

About the authors 05

Preface 06

1. ObjeCtive OF the 2012 UPdAte 07

2. Key COnCePts And deFinitiOns 08

2.1 What is private equity? What is not private equity? 08

2.2 Who are the parties involved in private equity? 08

2.3 What do private equity fund managers do? 09

2.4 How are private equity fund managers rewarded? 09

2.5 How is a buy-out completed? 10

2.6 What is leverage and how is it used? Amplification 11

2.7 What are the risks of leverage to investors and other stakeholders? 11

2.8 Borrowings in a fund and shareholder/investor liquidity 12

2.9 Information, management influence and ability to sell an investment 12

2.10 Alignment: economic theory, corporate governance and the

principal-agent problem, equity not bonuses 13

2.11 Taxation in the UK 13

2.12 3As: amplification, alignment and attention to detail 14

3. WhAt dO the CritiCs OF PrivAte eqUity sAy? 15

3.1 The general criticisms 15

3.2 Did private equity create or disseminate risk in the banking crisis? 15

4. WhAt Are the rOLes OF PrivAte eqUity mAnAgers? 17

4.1 Fund raising 17

4.2 Sourcing and making new investments 20

4.3 Active management of investments to improve performance 30

4.4 Exits 37

COntents

02 Private Equity demystified: 2012 update

5. regULAtiOn And trAnsPArenCy 43

5.1 What are the Walker Guidelines? 43

5.2 What is the Alternative Investment Fund Managers (AIFM) Directive

and what are its implications for private equity? 44

5.3 What are Transfer of Undertakings, Protection of Employment (TUPE)

regulations and when are they applied? 45

6. reCent deveLOPments in ACAdemiC reseArCh 47

6.1 Does corporate governance in public to private deals differ from

other listed corporations before buy-out? 47

6.2 What is the investment performance of funds? 47

6.3 What is the impact of private equity on employees? 48

6.4 How does taxation impact on private equity-backed companies? 49

6.5 Do private equity deals involve the short-term flipping of assets? 50

6.6 What is the extent of asset sales? 50

6.7 Do the effects of private equity continue after exit? 50

6.8 What do secured creditors recover in failure? 50

6.9 Does higher leverage lead to increased likelihood of failure? 51

6.10 Where do buy-outs get the cash to pay down the debt? 51

6.11 To what extent do private equity deals involve strategies

to grow the business? 52

6.12 Do private equity deals and buy-outs have adverse effects

on investment and R&D? 52

6.13 To what extent is replacement of management important? 52

6.14 To what extent are managerial equity, leverage and private equity

board involvement responsible for performance changes? 52

6.15 How are portfolio company management incentivised and rewarded? 53

7. WhAt Are the PrOsPeCts FOr the PrivAte eqUity indUstry? 54

7.1 Where will future deals come from? 54

7.2 Where will private equity deals be exited? 54

7.3 How will value be generated in future? 54

8. sOme AreAs FOr FUrther reseArCh 57

APPendix: sUmmAries OF stUdies OF bUy-OUts And PrivAte eqUity 58

reFerenCes 77


2. Key COnCePts And deFinitiOnsFigure 2.1: Typical participants in a leveraged buy-out 10Figure 2.2: Relationship between debt and returns 11Figure 2.3: Debt and the risk of losing equity 12

4. WhAt Are the rOLes OF PrivAte eqUity mAnAgers?Figure 4.1: Sources of new investment 20082010 17Figure 4.2: Funds raised by source 20082010 18Figure 4.3: Dry powder by vintage 20082010 19Figure 4.4: UK buy-out market by value 20Figure 4.5: UK buy-out market by number of transactions 21Figure 4.6: UK buy-out market by number of transactions: % MBO versus % MBI/IBO 21Figure 4.7: UK buy-out market by number of transactions: MBO versus MBI/IBO 22Figure 4.8: UK buy-out market by value: MBO versus MBI 22Figure 4.9: UK buy-out market by value: % MBO versus % MBI/IBO 23Figure 4.10: UK private equity-backed deals market: new deals versus secondary buy-outs by value 24Figure 4.11: UK market: secondary buy-outs as a percentage of total private equity-backed deals 25Figure 4.12: Buy-outs from insolvency as a percentage of all UK buy-outs 26Figure 4.13: UK buy-out market: number of transactions by size band 27Figure 4.14: UK buy-out market: % of transactions backed by private equity by value bands 27Figure 4.15: Debt lent to UK buy-outs 28Figure 4.16: Percentage of equity and debt in UK buy-outs 29Figure 4.17: Buy and build acquisitions by buy-outs 31Figure 4.18: Buy and build acquisitions as a % of total new investment 31Figure 4.19: Realised versus unrealised value by vintage of the fund 2010 32Figure 4.20: Enterprise value, equity value and asset value 33Figure 4.21: Value per 1 invested in UK private equity firms distributed and undistributed value 35Figure 4.22: Total return per 1 invested by vintage of fund 35Figure 4.23: Upper, lower quartile and median returns 36Figure 4.24: Range of returns distribution per 1 invested by vintage year since inception

to December 2010 36Figure 4.25: Inter-quartile range by vintage to December 2010 37Figure 4.26: UK exits by number 38Figure 4.27: Exits of buy-outs over 10m by year of investment 38Figure 4.28: Average time to exit for private equity-backed buy-outs by year of exit 39Figure 4.29: Exits by value 39Figure 4.30: UK private equity-backed buy-out/buy-in receivership/administration exits (%)

by vintage year 41Figure 4.31: UK buy-out receiverships/administrations as a percentage of all UK

company administrations 41

5. regULAtiOn And trAnsPArenCyTable 5.1: Private equity firms and portfolio company compliance with the Walker Guidelines 43

7. WhAt Are the PrOsPeCts FOr the PrivAte eqUity indUstry?Figure 7.1: Building the future for private equity 56

List OF FigUres And tAbLes


This report has benefited immeasurably from the support and positive criticism of a number of people, including anonymous reviewers and colleagues within both PKF and The Centre for Management Buy-out Research at Imperial College Business School. Our eternal thanks go to Katerina Joannou at ICAEW for her encouragement and forbearance. All errors and omissions are entirely our own responsibility.

Giles Derry, Dunedin; Mark Hammond, Caird Capital; Jim Keeling, Corbett Keeling and Jon Moulton, Better Capital gave of their valuable time. Thanks also to Robert Hodgkinson and Debbie Homersham, ICAEW and Nick Toyas, NT&A.

ACKnOWLedgements


AbOUt the AUthOrs

John Gilligan is a Corporate Finance Partner in PKF (UK) LLP. He has worked in the private equity and venture capital industry for over 20 years. He started his career in 1988 at 3i Group plc as a financial analyst. He joined what is now Deloitte in 1993 and was a partner from 1998 to 2003. He is a Special Lecturer at Nottingham University Business School and has also taught at Cranfield University Business School. He has a degree in economics from Southampton University and an MBA in financial studies from Nottingham University.

Professor Mike Wright is Professor of Entrepreneurship at Imperial College Business School and has been Director of The Centre for Management Buy-out Research since 1986. He has written over 25 books and more than 300 papers in academic and professional journals on management buy-outs, venture capital, habitual entrepreneurs, corporate governance and related topics. He served as an editor of Entrepreneurship Theory and Practice (199499) Journal of Management Studies (20032009) and Journal of Technology Transfer (2008-2011). He is currently an editor of the Strategic Entrepreneurship Journal. He holds a BA (CNAA), MA (Durham), PhD (Nottingham) and honorary doctorates from the Universities of Ghent and Derby. He is the winner of the Academy of Management Entrepreneurship Division Mentor Award 2009 and Chair of that Division in 20112012. He is a member of the British Private Equity and Venture Capital Association Research & Advisory Board.

Contact details

john gilliganPartnerPKF (UK) LLPFarringdon Place20 Farringdon RoadLondon EC1M 3AP, UKT: +44 (0)20 7065 0241E: [email protected]

mike Wright Centre for Management Buy-out ResearchImperial College Business SchoolExhibition RoadLondon SW7 2AZ, UKT: +44 (0)207589 5111E: [email protected] of Management, Innovation and EntrepreneurshipUniversity of GhentTweekerkenstraat 2 9000 Ghent, Belgium


When we sat down to write the first edition of Private Equity Demystified the world was a somewhat different place. In the UK the Treasury Select Committee was investigating private equity to establish whether or not companies were over borrowing. It was completely routine for journalists to interchange the phrases private equity and hedge fund, without any apparent appreciation of the differences between them, and very few people had any understanding of the fragile interconnectedness at the heart of the banking system.

The concerns at that time were what would happen to private equity if the long run of economic stability and favourable lending came to an end? Could the growing private equity industry sustain a downturn, and if so, how would the investee companies and the wider group of employees and trading partners fare?

No one anticipated the severity of the test that was to come, but a shock certainly happened. The credit crunch followed by a near global recession of unprecedented length started almost as soon as we put our pens down and went to press.

From a purely research, rather than a human perspective, this is a very silvery cloud; it gives us the opportunity to see what happens after a huge discontinuity in the economic environment. It is against this background that, five years after we originally started, we revisit the subject for the third time to see what, if anything, has changed and what has been learned.

Perhaps the biggest surprise is how little of what we originally wrote needed revision.

john gilligan mike Wright

April 2012

PreFACe


1. ObjeCtive OF the 2012 UPdAte

Private Equity Demystified: 2012 Update addresses the key changes in the buy-out sector since Private Equity Demystified 2nd edition was published in 2010. The update is a survey of developments in the private equity sector, in academic research and European regulation and forms a stand-alone summary of the earlier, more comprehensive, work.

Since 2010, the private equity and buy-out sector has continued to adapt to the post-boom climate yet, despite changes, much of what was written in the second edition remains valid. The 2012 Update reflects that fact and should therefore be read in conjunction with the second edition where more detailed analysis is required regarding:

private equity fund structures;

the differences between private equity and hedge funds;

the mid-market and large buy-out market;

evaluating and structuring a private equity investment; and

the dynamics of a leveraged buy-out and a restructuring.

Both publications may be downloaded from icaew.com/financingchange.


2.1 What is private equity? What is not private equity?

Private equity is risk capital (equity) provided outside the public markets (hence private, as opposed to public). Private equity is about buying stakes in businesses, transforming businesses and then realising the value created by selling or floating the business. These businesses range from early stage ventures, usually termed venture capital investments, through businesses requiring growth capital to the purchase of an established business in a management buy-out or buy-in. Although all these cases involve private equity, the term now generally refers to the buy-outs and buy-ins of established businesses and these are the focus of this study.

Private equity investments are illiquid and traded only on acquisition or exit (although this is changing). Generally, but not always, private equity managers have very good information prior to making their investment through their due diligence processes and during any investment through contractual rights and close involvement with the investee company.

Private equity is not about trading on public markets, or trading in currencies, bonds or any other publicly quoted security or derivative. These are the realm of other fund managers including hedge funds.

Investors in public markets buy liquid assets (shares, bonds and options) and generally use a trading strategy to try and make exceptional returns. Insider dealing laws are designed to prevent anybody from making exceptional returns from private information not available to other participants in the public markets. These types of investors sell out of companies when they think that they are no longer likely to generate good returns. In summary, they have high liquidity and trade frequently on the basis of publicly available information.

Although private equity funds have traditionally been seen to lie at the opposite end of the spectrum from hedge funds, there is some blurring of the distinction as some hedge funds have become involved in active management of investee companies and the acquisition of unquoted shares.

2.2 Who are the parties involved in private equity?

The parties to a private equity transaction are:

the private equity fund manager (who generally manages pooled money in the private equity fund on behalf of the investors in the fund, although there has been recent growth in managed accounts and direct investing);

the private equity fund a pooled investment fund invested in by the investors in the fund, including the senior members of the private equity fund managers;

the company, including both its shareholders and its management; and

in the case of a leveraged buy-out, the bank proposing to lend money.

Each of these parties has their own perceptions of risk and expectations of reward and will negotiate with the others.

2. Key COnCePts And deFinitiOns


2.3 What do private equity fund managers do?

Private equity fund managers have four principal roles:

1. Raise funds from investors. These funds are used to make investments, principally in businesses which are, or will become, private companies.

2. Source investment opportunities and make investments.

3. Actively manage investments.

4. Realising returns primarily through capital gains by selling or floating those investments, but also from income and dividend recapitalisations.

Fund raising: funds are raised from investors internationally, such as pension funds, banks, insurance companies as well as high net worth individuals. These investors will generally invest via a limited partnership, as will the private equity fund managers themselves. The largest investors in private equity are pension funds.

sourcing investments: a private equity fund must source and complete successful transactions to generate profit and support the raising of further funds. A significant amount of effort and resource is invested in prospecting for transactions and relationship management with individuals who may give access to deals. These include investment bankers, accountants and other advisers and senior figures in industry. Increasingly, investment teams are focusing on particular sectors of the economy. This contrasts with early buy-out experience where investors were usually financial experts rather than sector specialists.

Active management of investments: private equity fund managers have become hands-on managers of their investments. While they do not generally exercise day-to-day control, they are actively involved in setting and monitoring the implementation of strategy. This is the basis of the argument that private equity has become an alternative model of corporate governance.

realising capital gains: the industry generally now talks of a four to six-year exit horizon, meaning that the investment will be made with the explicit assumption that it will be sold or floated within that timeframe. This exit horizon is the source of the criticism that private equity is a short-term investment strategy.

2.4 how are private equity fund managers rewarded?

Private equity fund managers are generally rewarded with an income and a share of other income and capital gains known as carried interest:

Fee income: fund managers receive management fees that are expressed as a percentage of the funds raised. The larger the fund, the greater the fee income, although the percentage generally declines from around an occasional 3% in a few smaller funds to 11.5% in larger funds. This fee income pays for the operating costs of the fund managers business and any excess belongs to the partners of the fund management company. Therefore, there is an incentive to maximise the fund size (consistent with the investment opportunities for the fund) in order to increase the management fee income. Critics have argued that as fund size has grown, the funds costs have grown less rapidly and therefore the profit from fee income has become material. It is argued that this income, which is effectively guaranteed, has created a misalignment between the partners in private equity funds and their investors. In essence, a new principal-agent problem is said to have been created by the high levels of guaranteed income from fees. Private equity funds may also receive deal fees for various services that they provide to the portfolio company. These include transaction fees paid by the portfolio company for costs incurred by the private equity firm in making the investment and monitoring fees which portfolio companies pay to their private equity investors each year for advisory services.


At the time of writing, there is debate about what is happening to fees. Some survey evidence suggests that fund management fees are being squeezed while transaction and monitoring fees have been rising. Anecdotally, other evidence indicates that limited partners (LPs) are requiring transaction and monitoring fees to be reduced or attributable to the fund rather than the management company. The pressures may differ according to market segment; in the mid-market, LPs may be more comfortable with management fees being maintained at current levels while management fees are under greater pressure with larger funds.

Carried interest: the second source of reward for private equity fund managers is a share in the profits of the fund; this is generally known as carried interest. Once the investors have achieved a certain pre-agreed rate of return (called the hurdle rate), usually the fund managers will share 20% of any excess. The hurdle rate (historically around 8% per annum) is calculated on the amounts actually invested. As the market has matured there has been a constant refinement of industry practice to attempt to ensure that the carried interest calculation tightly aligns the interests of investors and fund managers. However, in a long-term, illiquid investment business with low levels of transparency to new entrants, this process of realigning interests may take longer than in other industries. Management fees can be structured as an advance of carried interest.

2.5 how is a buy-out completed?

A new company (Newco) is typically formed to make the acquisition of the company that is the subject of the buy-out. Funds are invested in Newco by the private equity fund, the management team and the bank. Newco then makes an offer to acquire the company that is the subject of the buy-out.

If the offer is accepted by the shareholders of the buy-out company, after the transaction completes the target company becomes a wholly owned subsidiary of Newco and is therefore owned by Newco.

Newco is in turn owned by the private equity fund and management (and any other shareholders of Newco).

Figure 2.1: typical participants in a leveraged buy-out

NewcoTarget

company

Banks

Suppliers

Customers

Employees

Shareholders

Pensionfund

trustees

Management

NegotiationPrivateequity fund

Negotiatio

n

Negotiation


2.6 What is leverage and how is it used? Amplification

Private equity firms use both the money that they manage to invest in equity and also raise further funds from banks to top up the price that they pay for any business. The use of bank debt is termed leverage (or gearing) because it amplifies the returns on the equity invested, much as a lever (or a gear) amplifies the effect of a physical force. Figure 2.2 shows that as the amount of equity decreases (and the debt correspondingly increases) the returns on equity are amplified. This happens because debt has a limit to its return (its interest rate) whereas equity owns the amount that is left over after everyone else has been paid. If you increase the amount that has a fixed return, you amplify the returns on the balancing equity.

Figure 2.2 also illustrates the amplification of gearing in an investment that doubles in value. When funded by 50% equity: 50% debt, returns increase from 200% to 300%. Increasing leverage further shows that as the equity percentage falls to 10%, the returns rise to 1100%. So, not only does leverage amplify returns on equity, it increases the amplification the greater the borrowings.

Figure 2.2: relationship between debt and returns

2.7 What are the risks of leverage to investors and other stakeholders?

It is a general rule of economics that where there are higher returns there are higher risks. The same rules naturally apply to private equity as any other investment type. In general terms the less equity invested in any given acquisition, and correspondingly the higher the amount of debt, the greater the risk of losing the equity.

Furthermore, the less equity that a company has, the smaller the cushion against banking problems and insolvency or failure. Therefore, high leverage increases both the risk of losing the equity invested and increases the risk that a company becomes unable to repay its bank and therefore becomes insolvent.

The increased risks of high leverage are borne by both the investors and any other stakeholders in the business. Conversely, any business that is under-leveraged will generate lower than market returns for its investors and provide lower than market risk to its wider stakeholders.

% return on equity in

vested

% of price funded by equity invested

0

200

400

600

800

1000

1200

10 20 30 40 50 60 70 80 90 100

1100%

600%

433%

350%300% 267% 243% 225% 211% 200%


Private equity therefore uses leverage to consciously increase risk in the anticipation of making exceptional profit.

In the example below we plot the amount by which the value of the company must fall to wipe out the equity value against the gearing or leverage. Again, the leverage amplifies the risks including that of losing the equity and amplifies them more at higher levels of borrowing.

Figure 2.3: debt and the risk of losing equity

2.8 borrowings in a fund and shareholder/investor liquidity

With a few exceptions, private equity puts all the gearing in each individual Newco investment, tailored to that investments characteristics. Hedge funds and many other quoted investment fund managers mostly put the gearing in the fund itself and hold a diversified portfolio of investments that may, or may not, be individually geared.

We believe that this distinction is important in understanding the market risks created by hedge funds and private equity funds and for informing regulatory responses to the systemic failures seen in the past few years. In particular we have argued that the level of leverage needs to be understood by reference to the entire investment chain. We argue that the traditional private equity fund structure has operated to limit systemic risk by offering long-term, illiquid, unleveraged investment assets to investors with large diversified portfolios. We noted in the second edition the appearance of pressure to increase leverage within funds and to provide liquidity to investors. We argued that if the pressure led to geared private equity funds it would lead to increased systemic risk. We noted that the debt-free structure of a private equity fund was, in most European jurisdictions, a market-driven norm, not a regulatory requirement.

The contribution, if any, of the private equity industry to the market failures seen in 2007/2008 arose through failures in the associated acquisition finance banking market, not within the private equity fund structures. On this analysis the private equity industry was a (wholly willing) victim of a failure of the banking system, not a cause of the failure.

2.9 information, management influence and ability to sell an investment

Risk can be mitigated and managed by buying assets that are easy to sell and by having as much information as possible before and during an investment. If you can have both liquidity and good, timely information, you can achieve consistently superior returns

Probab

ility of losing equity in

vested

% of equity invested

10 20 30 40 50 60 70 80 90 100

Higherrisk

Lowerrisk


with lower risks than other market participants. That is one major reason why insider dealing in quoted shares is illegal. In reality you usually have to trade liquidity for information rights.

Similarly, you can adopt either an active investment stance and seek to influence the management of the company, or a passive one and simply sell out if you perceive management to be weak or taking the business in the wrong direction. If you have decided to trade liquidity for information you lose the option to trade out of investments that are not going in the direction you hoped. Private equity funds are illiquid and therefore are generally active investors.

2.10 Alignment: economic theory, corporate governance, the principal-agent problem, equity not bonuses

Economic theory suggests that in a perfect market, risk and reward are always matched so that you cannot make exceptional returns without creating equal and opposite exceptional losses. So how do private equity firms justify their increase in risk taking?

Economic theory also argues that there is a principal-agent problem in many companies whereby managers (who act as agents of shareholders) are not incentivised to maximise the value to the shareholders of a corporation (who are the absent principals who own the company).

It is argued that this lack of accountability of senior managers has allowed them to pursue projects that are either excessively risky or, conversely, excessively conservative. This is one of the central problems facing what is known as corporate governance: how do shareholders make managers accountable for their decisions?

Private equity seeks to capitalise on the market failure caused by this principal-agent problem. It does this by changing incentives to tightly align the economic interests of managers and shareholders to achieve efficiencies. Furthermore, the alignment is structured in such a way that unless the efficiencies increase the value in cash to all shareholders, no value accrues to the managers. Generally, therefore, private equity-backed companies do not pay material cash bonuses to senior managers. They are expected to get their returns if, and only if, the business is sold or floated. The return therefore comes as a capital gain not in a higher income.

This idea of alignment is central to all the economic structures observed in the private equity market. Some argue that private equity is an alternative long-term form of corporate governance to traditional public companies. Others see private equity as a type of transitional shock therapy for under-performing companies.

2.11 taxation in the UK

There have been a number of misconceptions about the taxation of private equity. The first thing to say is that all the participants are treated exactly the same as anyone else in their position; there are no special loop holes for private equity of any kind whatsoever.

However, it is true that the industry legitimately seeks to minimise its tax liabilities (as does every industry). The critics point to:

deductibility of interest on loans which reduces corporation tax in a company;

capital gains which are currently taxed at a preferential rate to income;

private equity limited partnerships which are not taxed (the partners themselves are); and

private equity firms which are often structured with offshore structures.


Some of these criticisms may have been true in the past but take no account of the changes in legislation since they were first made. Interest deductibility, for example, has changed very materially over the past 20 years with the explicit objective of preventing the deduction of interest on loans not on commercial terms. Similarly, the capital gains tax regime has changed many times over the past two decades as policy has sought to incentivise investment and entrepreneurship without creating distortions in the overall tax system.

The criticisms that limited partnerships are not taxed are based upon a simple misconception. Partnerships are intended to be invisible to the tax man. The central idea is that the partners pay the tax, not the partnership. A fuller explanation is in Private Equity Demystified 2nd edition.1

2.12 3As: amplification, alignment and attention to detail

In summary, the key concepts behind private equity are amplification of returns by using debt and incentivising capital growth by encouraging alignment and attention to detail. These are coupled with a focus on the detailed structures put in place while an extensive use of professional advisers ensures that every level of a buy-out organisations legal structure and its investments are made in a tax efficient manner.

1 It was argued by one of the high-profile private equity investors, David Rubenstein of Carlyle Group, that the attack on private equity tax strategies by its critics was misjudged and misdirected. He argued that private equity investors were not cheating the revenue authorities; they were simply applying attention to the details of their tax affairs in a lawful and legitimate way. He went on to argue that if society wanted private equity to pay more tax, the rules should be changed to achieve that.


3. WhAt dO the CritiCs OF PrivAte eqUity sAy?

3.1 the general criticisms

Any industry has its critics. Critics of course can be mistaken or ill-informed as well as being correct. Our objective in writing this series of publications has been to eliminate the criticisms that were based on errors and to attempt to summarise the academic evidence on the genuine areas of debate.

Private equity has been criticised both for the way in which it finances and operates individual investments and operates its own business.

At the level of the individual investment, the criticisms include:

using excessive levels of debt to acquire corporations;

using complex structures to reduce or eliminate tax;

aggressively managing businesses to reap short-term profit at the expense of long-term performance;

under-investment in new products and process;

lack of consultation with workers prior to and after an acquisition.

At the level of the fund, the criticisms include:

a lack of public information on the funds and their investors;

criticisms of the compensation of partners and staff of the funds;

concerns on the minimum regulatory capital requirement of fund structures; and

reiteration of concerns regarding the use of tax havens.

Further concerns have been raised that are relevant to private equity transactions but are symptomatic of wider issues. For example, developments in the banking market materially changed the incentives and alignment of the parties concerned resulting in the banking market failures seen in the credit crunch.

As the body of work in these areas has expanded rapidly in recent years, we are able to start drawing conclusions about most of these criticisms. We return to these below and in the Appendix tables. It is little compensation, but the financial crisis created an almost perfect storm to test the private equity business model.

3.2 did private equity create or disseminate risk in the banking crisis?

As we have described and extensively illustrated, private equity relies on banking for funding to enable transactions to be completed and to amplify the returns of those transactions. Clearly, since 2008, there has been an unprecedented disturbance in the global banking market. We looked at the role of private equity in the banking crisis in the second edition where we argued that while private equity was a voracious consumer of cheap debt, the industry itself did not create or disseminate risk in the financial markets.


On the contrary, the structure of most private equity funds and their ring-fenced investments actively restricted the spread of risk from excessive borrowing by any of their individual investee companies. We concluded that contrary to pre-credit crunch speculation about the risks created by private equity, the investigation was probably looking in the wrong place. Individual companies may have borrowed too much but the banking markets were the predominant source of systemic risk, not the borrowers, including the private equity industry.

It has been argued that the rewards of private equity were so high that this helped to fuel a bonus culture across the financial industry that was a major contributory factor in the failure of the banking market. This argument could be understood in at least three different ways.

Firstly, it could simply be arguing that mimicry, or a perceived need to retain key staff who could leave to go to private equity funds, caused the widespread misalignment of interests between people who worked in financial services and the wider public.

Secondly, it could be an economic argument suggesting that due to some unspecified market failure, private equity earned economic super-profits.

Thirdly, it could be a general statement regarding equity, fairness and income distribution.

The first argument seems to us potentially to have some merit, but to be wholly inappropriately aimed at private equity. As we have described at length that the central ideas of private equity are alignment and amplification. Private equity has a great deal to teach others about how to align the incentives of senior people in organisations. We therefore consider this to be valid, but ill-judged when directed at private equity.

The second argument may have greater merit when applied to private equity. It is of course the case that some of the losses of banks were matched by the profits of borrowers and other counter-parties. Private equity is not the only industry that is predicated on large levels of borrowing; so too is the property investment industry. The private equity industry probably was a beneficiary of cheap debt due to market failure in the banking market, and continues to benefit from low interest rates for those deals currently able to borrow. However, the converse may also be true; the tightening of credit has, as we will show, adversely affected those who borrowed the most and borrowed most aggressively.

The third argument is a judgement about which we leave the reader to form their own opinion.

In summary therefore, we reject the hypothesis put forward that private equity as an industry was a material contributor to the causes of financial crisis, but are not able to reject the argument that the industry may have made exceptional profits during the boom that might otherwise not have been earned. This is of course what happens more often when you amplify returns by using debt.


4. WhAt Are the rOLes OF PrivAte eqUity mAnAgers?

Private equity fund managers have four principal roles:

1. Raise funds from investors. These funds are used to make investments, principally in businesses which are, or will become, private companies.

2. Source investment opportunities and make investments.

3. Actively manage investments to improve performance.

4. Realise capital gains by selling or floating those investments.

In this section we look at each of these activities separately to try and paint a picture of where we were, how we got there and of recent developments.

4.1 Fund raising

4.1.1 How much money is in the private equity market?

Around 75% of all private equity is invested through closed-end funds managed by independent fund managers. In the long run, without new funds to invest, there will be no private equity industry. In the wake of the crash new commitments to private equity funds (and many other investment classes) fell sharply.

Figure 4.1: sources of new investment 20082010

source: BvCA/PwC.

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Historically, the overwhelming majority of investment into funds managed by members of the British Private Equity and Venture Capital Association (BVCA) came from outside the UK. After the banking crisis this investment fell by over 95% and despite a recovery in 2010, was still 80% below its peak in 2007.

4.1.2 Who is investing in private equity?

Substantially the largest investors in private equity in the UK have been pension funds which have accounted for around 35% of all monies invested in private equity funds. The majority of these commitments came to UK-based managers from overseas. These commitments fell by similar percentages as overall investment levels.

Figure 4.2: Funds raised by source 20082010

source: BvCA/PwC.

The picture post-crisis was one of significant reductions in cash availability across the industry. Of course this analysis necessarily over-emphasises the large buy-out market, where fund sizes are substantially larger. According to the BVCA data, no large buy-out funds were raised in 2010.

4.1.3 Dry powder: what is left to invest from before the boom?

In other data published by the BVCA we can obtain an estimate of the amount of dry powder that might be awaiting investment. The data show that the pre-2004 funds were substantially invested at the end of 2010.

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Figure 4.3: dry powder by vintage 20082010

source: BvCA/PwC.

At the end of 2010 there was some 3bn of vintage 2005 funds uninvested. Even allowing for some follow-on investments in existing portfolio companies, it seems highly likely that commitments were cancelled, undrawn. Unless investment volumes recover soon the magnitude of this excess capital commitment will increase.

4.1.4 What do the changes in volumes and maturities mean?

For investors in private equity funds fees are generally charged based on committed capital during the investment phase (typically 46 years). If the capital is never invested, there is clearly a conversation to be had about the fees paid to the fund managers. Anecdotally, there have been significant and concerted efforts by investors to reduce the level of fees and to avoid this type of misalignment persisting or arising in future. This has seen both pressure on fee levels and greater scrutiny of what is actually paid and when.

For the fund managers there is extreme pressure to invest the capital, if it is possible to do so. Returning commitments materially undrawn is not the route to growing a fund management business. This appetite for risk comes at a time when banks are in a period of extraordinary risk aversion. Therefore, we expect to see more equity in deals with lower initial projected equity returns. To attempt to recover some of the value lost due to lower amplification of the winners, we expect to see continued aggressive negotiation during any sale or purchase process, especially during and immediately post-due diligence.

Furthermore, the organisation structures needed to invest and manage the largest funds is predicated on utilising the commitments and raising further funds with fee levels to service the enlarged overheads. If new funds are not being raised, fee income will fall. This can only result in either lower fixed rewards to staff working for private equity funds, or fewer people in the industry. Given the deal volumes discussed below, we expect both to be seen.

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Due to the long-term nature of the funds, if a fund manager has longevity, and therefore multiple funds of differing maturities generating fee income, they are less exposed than newer managers with one, or few, funds under management. The economics therefore make the managers with the most funds, the least likely to be distressed. However, private equity has been a highly personal business with a few so-called star investors being key to attracting investment. Inevitably the older the fund, the more likely it is that there is, or has been, a succession issue at the top.

For vendors of businesses thinking of selling to private equity, knowing whose funds are at what maturity might be considered a reasonable question to ask any advisers appointed.

4.2 sourcing and making new investments

At the heart of the industry is new investment.

4.2.1 What has happened to new investment volumes?

Data for the whole private equity market in 2011 are not available as we write. The buy-out data set for 2011 is however.

Figure 4.4: UK buy-out market by value

source: CMBOR/Ernst & Young/Equistone Partners Europe.

Figure 4.4 shows both the bubble leading up to the financial crisis and the subsequent collapse in the overall volume of buy-outs in the UK. From a peak in the year to Q1 2008 of 50bn, the market contracted to a trough in Q3 2009 below 6bn; a fall of nearly 90%.

By number, the collapse is equally clear, with volumes falling by around 45% from the peak (Figure 4.5).

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Figure 4.5: UK buy-out market by number of transactions


While the value of transactions has started to increase the volumes remain at the depressed levels of 2009/2010.

4.2.2 Auctions and the decline of the MBO

Breaking the data down by buy-out (MBO) versus buy-in (MBI/IBO) reveals two underlying trends. Firstly, there is a long-term trend against management buy-outs led by incumbent management teams (Figure 4.6). This trend is even clearer when a longer data run is analysed. Figure 4.7 shows that the once dominant MBO has been in relative decline over the entire history of the UK private equity industry.

Figure 4.6: UK buy-out market by number of transactions: % mbO versus % mbi/ibO


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The trend away from MBOs accelerated in the wake of the crisis and has shown no signs of recovering.

Secondly, there has been a recovery in the volume of investor led buy-ins since the lows of 2009. We examine the reasons behind this further below.

Figure 4.7: UK buy-out market by number of transactions: mbO versus mbi/ibO


Figure 4.8 separates out the more traditional MBO market, where managers lead a deal, from the buy-in market, where institutions are the leaders of the transaction, in terms of deal values.

Figure 4.8: UK buy-out market by value: mbO versus mbi


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While the long-run trend in the value of the MBO market is not as clear as it is in the volume data, there is evidence of a cyclical pattern. The MBO market never flew as high as the MBI market, but has nevertheless fallen by 8085% and has yet to recover in value terms (Figure 4.8).

The 11bn Alliance Boots acquisition by KKR contributed about 25% of the peak of the buy-in market and therefore exaggerates the bubble. However, there was a collapse in investment in 2009. In contrast to the MBO market there is clear evidence that after the collapse, a recovery in new investments began in early 2010.

Figure 4.9: UK buy-out market by value: % mbO versus % mbi/ibO


The data analysing the relative importance of MBOs and MBI/IBOs by value above again shows the sustained emergence of the institutional purchaser of businesses (Figure 4.9).

The reasons for this relate to the emergence of the practice of vendors auctioning companies. In the early days of the buy-out industry, management often expected to lead a transaction. They would appoint advisers who would raise funds to acquire a business from the vendors. In this process vendors had to attempt to manage a process that could lead to a trade sale or a management buy-out. The potential trade purchasers were understandably concerned about the impact on the business if the management team were the losing under-bidders. Similarly, the vendors had to manage the potential conflicts of interest with their own management teams who were both running the business and trying to buy it. The solution was the creation of the auction process by corporate financiers.

In an auction a sales document is prepared and circulated to potential interested parties including both private equity and trade buyers. The level playing field should eliminate conflicts for management and capture more of the value for the vendor. It also encourages private equity houses to team up with external managers in an attempt to gain a sector advantage, giving a boost to the MBI/IBO numbers at the expense of the MBO numbers.

This trend is virtually ubiquitous both in larger transactions and in disposals by private equity firms (secondary buy-outs). It largely explains why 90% by value of private equity lead deals are now MBI/IBOs rather than MBOs.

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If auctions generally increase the price paid for buy-outs by acquirers, there is a transfer of value from the purchasers to vendors. If prices are not higher as a result of the process, there is a leakage of value due to transaction costs. Other things being equal we would expect either of these to reduce returns when compared to past performance.

In addition to paying an increased price, there is a further downside as purchasers, with poorer access to management in any auction process, take on more risk as they lose access to managements inside view. This again might be expected to reduce returns in private equity overall. This problem may be exacerbated in the case of inexperienced investors lacking the expertise to undertake adequate due diligence.

If the pure MBO has declined, what are the sources of new investment opportunities?

4.2.3 New investments and secondary buy-outs

In earlier editions we looked at the sources of buy-outs and analysed the relative importance of private and public companies versus, say, subsidiaries of larger organisations. In this section we focus on the recycling of transactions within the private equity industry via so-called secondary buy-outs. A secondary buy-out is a transaction where one private equity fund acquires a business owned by another. It contrasts with a primary transaction when a private equity fund acquires a business from anybody other than a private equity fund (a private company, a public to private, or a division of a company). The data show that while the dislocation of the banking crisis caused the overall market value to fall dramatically, secondary buy-outs had been increasing as a proportion of the market and account for an increased proportion of transactions in 2011 (Figure 4.10).

Figure 4.10: UK private equity-backed deals market: new deals versus secondary buy-outs by value


The pattern of primary versus secondary investments is very similar, by value, with secondary transactions accounting for a significant proportion of transactions. Despite a fall off in the dislocation that followed the banking crisis, we find that the numbers of secondary deals have been rising and at the time of writing some 2530% of all buy-outs are now transactions between private equity houses (Figure 4.11).

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Figure 4.11: UK market: secondary buy-outs as a percentage of total private equity-backed deals


There is debate about whether or not the private equity model is a form of shock therapy for underperforming companies, or a long-term corporate governance structure that may or may not generate superior outcomes. If it is shock therapy, it has traditionally been seen as working only once. If it is an enduring system of governance there are gains to be made from secondary buy-outs. Yet the emergence of secondary buy-outs also introduces the possibility for shock therapy every few years that reinforces the private equity model and offers the opportunity for sustained gains.

Secondary buy-outs raise significant questions for investors in private equity. Firstly, it is possible that an investor with a portfolio of investments in various funds may be advancing cash to the acquiring fund to purchase a company within the portfolio of another of the investors funds. The investor may view themselves as funding the purchase of business that they already part own, and paying both transaction fees and carried interest for the privilege. Estimates suggest that total transaction costs to underlying investors are about 10% of their investment.

The counter argument is that any publicly-owned asset also has owners and the largest investors in private equity are also investors in other public assets. Only private companies could be guaranteed to be outside the investment portfolio of any individual investor. There is of course no guarantee that investors in a given fund do not acquire public companies that a particular investor owns via another fund. The probability of the issue arising is determined by each investors asset allocation. The more that is allocated to a portfolio of private equity funds operating in a similar area of the market, the more likely it is to occur. In the final analysis investors are backing fund managers who they believe can achieve higher returns due to their skill and connections and should accordingly give them the freedom to pursue the opportunities that they see as attractive.

There are a number of under-researched questions that arise from this potential conflict; how commonly does the situation actually arise? What is the significance of transaction costs in value distribution? What is the performance of secondary versus primary transactions in the long run? Is there a cohort of private equity funds that are disproportionately active in primary transactions, and if so do they have better or worse returns? Conversely, are there funds that are disproportionately invested in secondary deals and how do they fare?

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These are important partially or wholly unanswered research questions that address the central question regarding the sustainability of performance with a private equity system of corporate governance.

4.2.4 Buy-outs from insolvency

As we described in the second edition of Private Equity Demystified, the origin of buy-outs lies in the Companies Act 1981 which changed UK law in a way that enabled companies to be acquired using borrowed funds. The idea at that time was to facilitate the rescue of companies and divisions of companies that had either failed or were failing and could be rescued. The industry has obviously moved a long way in 30 years, but nevertheless we might expect that some of the excesses of the pre-crisis banks and the subsequent recession might throw up opportunities to invest to rescue viable businesses.

The evidence is clear that, in general, private equity is not usually a significant buyer of companies that are in insolvency as primary buy-outs, although as this report goes to press there have been notable examples in the first quarter of 2012. This might reflect the fact that transactions happen without a formal insolvency occurring, or that portfolio companies acquire insolvent companies. With less than 10% of gross investment in these types of transaction in a typical year, they are exceptional transactions, not the norm (Figure 4.12).

Figure 4.12: buy-outs from insolvency as a percentage of all UK buy-outs


4.2.5 Private equity and smaller transactions: developments in the UK

In November 2009 The Provision of Growth Capital to Smaller and Medium Sized Enterprise widely known as the Rowlands Report, was published in the UK. It examined how private equity addressed the needs of smaller companies that might grow more rapidly if they received equity investment. The report is extensive and covers the issues more fully than we could or would wish to. It highlights a number of reasons why there may be a funding gap that is not addressed by private equity. The analysis splits the issues into demand side (company) and supply side (investor) factors. Distilling a comprehensive work to some simple statements, the issues include; fixed transaction costs making returns lower than in larger deals; a lack of information to potential investors increasing perceived risk and therefore required return and; a lack of information to companies leading to a propensity to fail to be investment ready or to shy away from pursuing growth in order to maintain control.

The establishment of the Business Growth Fund was designed to fill the growth capital gap.

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We do not intend to rehearse the arguments of the Rowlands Report, but it is interesting to note that the number of smaller buy-outs has been in long-term decline over the whole of the past decade. Although Figure 4.13 relates to the UK, a similar trend is evident elsewhere.

It is one of the striking features of this analysis that the credit crunch accelerates a pre-existing decline. An examination of the data set without any knowledge of the background, would probably conclude that whatever started the decline happened in the period around 20022003.

Figure 4.13: UK buy-out market: number of transactions by size band


The proportion of transactions involving private equity has fluctuated at between 2030% of the smaller buy-out market (Figure 4.14). This of course may reflect the fact that smaller transactions do not require external equity, or it may be that institutions are also being driven out of the small buy-out market for all the reasons identified by Rowland.

Figure 4.14: UK buy-out market: % of transactions backed by private equity by value bands


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4.2.6 Transaction structures and the fall in amplification

The single biggest factor impacting the private equity industry has been the reduction in the availability of debt to fund transactions.

Figure 4.15: debt lent to UK buy-outs


If one graph tells the story of the new investment market, it is Figure 4.15. It clearly illustrates the precipitate decline in lending to new transactions in the UK. It also alludes to the second financial hangover facing the private equity industry as discussed below.

4.2.7 Debt maturity: another lump in the snake

During the boom, debt was raised both in higher volumes than previously experienced and on terms that were less onerous than in previous years. We discussed cov-lite loans and payment in kind (PIK) loans in earlier editions: these are loans that weaken the ability of banks to foreclose and reduce the on-going cash requirements of the loan respectively. They effectively defer both the transfer of power to the banks in a distressed situation and simultaneously defer the ultimate cash repayment of the loan.

These loans were typically 710 year loans made between 20052008 and were assumed to be refinanced by sale of the business or by re-borrowing from banks monies that had previously been repaid. There is therefore a very large refinancing requirement working its way through the system. With banks seeking to increase capital ratios and reduce risk it is likely that this lump in the snake will not be refinanceable on the basis of the original investment assumptions.

The possible outcomes include:

insolvency: this is unlikely if the underlying business is viable.

extend (and pretend?): it is of course entirely possible to renegotiate the terms of any debt package, indeed the assumption of many structures put in place was that this would happen during the life of the investment. Cynics have characterised this as extending the term of the loans and pretending that it has solved the problem. The truth of course varies depending on the prospects of the underlying business. As we explained in detail in the earlier editions of this work, excluding grants, there are only four sources of cash in a business:

profits;

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increased capital efficiency;

reduced taxation; or

an external borrower of investor.

Only if the underlying cash generation can service the funding structure will a restructuring work. The dynamics of a restructuring is discussed at length in the second edition.

transfer of ownership from the private equity house to the lending banks: This has occurred in a number of cases. It raises questions about the long-term suitability of banks as owners of trading businesses. At best it would appear to be a stop-gap solution.

banks trading out of loan positions by selling to investors prepared to hold this risky debt: The purchasers of this debt include specialist funds, including funds established by traditional private equity investors for the purpose. Furthermore, a few private equity funds have gained agreement to buy back debt in the companies in which they are invested. Effectively, this action de-risks the equity investment by buying the debt that was threatening to cause a default. Unless the terms of this debt change in the course of the transaction there is no change in the underlying liabilities of the company, and therefore no change in the risks for the company. This can be superficially addressed by injecting equity into the company to buy back its own debt at a discount to its face value. The value of this depends on the relative cost of the equity and the debt bought back.

4.2.8 Has the market responded to lower debt availability?

With lower debt availability and limited life funds pressing to be invested, investors have increased the proportion of equity in new investments.

Figure 4.16: Percentage of equity and debt in UK buy-outs


The increased proportion of equity and reduced proportion of debt will reduce the amplification of returns in the future and therefore reduce the returns to the funds (Figure 4.16).

There are essentially three ways to maintain returns with reduced debt and therefore reduced amplification at the purchase date.

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First and most certain to improve returns, is to pay less for each investment. However, with the private equity industry funded and resourced for a boom that has ended, competition for any deal is intense and it is difficult to see why a general improvement in pricing would emerge in that competitive environment.

Second is to enhance the value of each investment to a greater extent. This means private equity firms being actively involved in greater efforts to assist portfolio companies.

Third is to re-engineer the investments to increase debt and therefore amplify returns post-acquisition, if the banking market returns. However, given the rate of recovery of banks balance sheets this may be outside the timeframe of most investments.

We therefore expect to see absolute returns diminish over the coming years. It is less clear whether the variance of returns will decline. This is important to both investors and private equity managers; in future a higher proportion of the return to any investment will probably come from operational improvements in the business and less from financial engineering.

4.3 Active management of investments to improve performance

The third role of a private equity investor is that of active ownership, what we characterise as attention to detail. In what is essentially an empirical update there is only a limited amount of hard data that can cast any light on the day-to-day activities of private equity fund managers. Since the first edition of Private Equity Demystified in 2008, there has been an explosion in the number of books, studies and research groups looking at private equity. The evidence of the papers and case studies produced by these generally qualitative academic studies shows that private equity firms are very hands-on owners. They create active boards involving high levels of interaction with executives. On average, in contrast to some quoted companies, the boards of private equity-backed companies lead strategy through intense engagement with top management. The close involvement draws on previous experience and any industry specialisation of private equity firms. In some cases the behaviours are in many ways comparable to the way that the methodological consultancies behave towards clients. The private equity firms have evolved processes and procedures post-investment to attempt to ensure that the maximum value is extracted from the business. It is increasingly common to see one hundred day plans agreed pre-completion to formalise the detailed actions that are to be taken after the deal completes.

Leaving aside potential manipulation of financial reporting between deal entry and exit, the evidence available from academia generally supports the view that these active engagements do create increased profitability.

4.3.1 Platform investments and buy and build strategies

The data collated by The Centre for Management Buy-out Research (CMBOR) under the supervision of one of us is the longest and most complete data set on buy-outs in the world. As the industry has developed that data set has been expanded and modified to allow light to be shed on the various emerging issues.

A data series that has been built over the last few years looks at an area that has to date escaped most attention: buy-outs as platform investments to follow a buy and build strategy.

Buy and build is nothing new; many large corporations grew by acquisition. What is relatively new, however, is the emergence of private equity groups which specialise in acquisitive growth by actively consolidating narrow sectors of the economy. These firms are marketing their skill as acquirers as well as their skill as stock/management team pickers.


Figure 4.17: buy and build acquisitions by buy-outs


The number of bolt on acquisitions to existing buy-out investments remained remarkably robust when compared to the precipitate drop in new buy-outs completed (Figure 4.17). This continued support for existing investments has resulted in some 30% of all businesses acquired using private equity being acquired by existing portfolio companies (Figure 4.18).

Generally, these are materially smaller than the platform investment, with only around 510% of gross investment going to fund these acquisitions. This new data set points to the importance of private equity as an agent to structurally change industries; this volume of acquisitive activity represents a significant proportion of all mergers and acquistions activity in the UK.

Figure 4.18: buy and build acquisitions as a % of total new investment


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4.3.2 Portfolio performance

We have discussed the so-called J curve effect at length in the past; the idea that the cash flows of an investor are necessarily cash out followed by realising profits some time later. Failures also tend to occur before successes; the idea is captured by the colloquial phrase lemons ripen faster than plums. These two factors make assessing recent investment performance problematic.

In the long run only the cash invested and the cash returned to investors matters, but private equity is a long-term investment horizon and at any date before a fund is finally fully distributed the total return to an investor consists of cash received plus the value investments in the portfolio (plus or minus any future new investment returns yet to be made) ie:

Total investment return = Realised value + Unrealised value

While the timing of receipts will materially affect the actual rate of return on the investment, as a good first proxy the value per 1 invested provides a good pointer towards investment performance.

The BVCA has responded to the demands for more openness by publishing (with PwC) data on portfolio performance since 2007 which includes both rates of return and value per 1 invested data.

This work provides an excellent lens through which to examine both the characteristics of the investment class and the most recent performance data.

When we look at the relative proportions of value realised and still invested it is abundantly clear that in aggregate the vast majority of the value of investments made since 2005 is, at the date of the last analysis (end 2010), unrealised (Figure 4.19).

Figure 4.19: realised versus unrealised value by vintage of the fund 2010

source: BvCA/PwC 2010.

Given the preponderance of investment in the last decade, it is true to say that the jury is still out on whether or not returns have been maintained as the industry grew.

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The total return to the aggregate sample across the three years analysed gives some indication of the way the last three years have impacted portfolios. In summary, portfolio value per 1 is higher in 2010 than in either of the previous two years for which we have data in all vintages. The industry sample was showing aggregate losses/breakeven for the funds raised in 20062009 but each of these vintages (which are of course still investing) are now showing improved, positive returns, albeit so far well below the long-run results of earlier vintages.

4.3.3 A brief digression on valuation

As competition for new funds has grown, so has the importance of valuations and we briefly summarise the differences between equity value and enterprise value (Figure 4.20). For a detailed description please see the second edition.

When talking about structuring any transaction it is of utmost importance to understand what is meant by the terms price and value. There are two widely used, but different, measures of the value of a business:

Equity value or market capitalisation is the value of 100% of the shares of the business. It measures the equity value after all other claims on the business, including debt, have been deducted. P/E ratios (price earnings ratios) measure the ratio of equity value: post-tax profits (note that as published, most P/E ratios are based on profit before tax less notional tax at the mainstream corporation tax rate, not the companys actual tax rate, if it is different).

Enterprise value is the debt-free/cash-free value of the operating business. Enterprise value is measured by reference to profit before interest and tax (EBIT) or profit before interest tax, depreciation and amortisation (EBITDA) and reflects the value of the business regardless of how it is financed.

Accounting value is the net book value of the assets and liabilities of the business. These are generally stated at the lower of cost or net resale value. If a company is acquired for more than its net asset value, the excess is the accounting goodwill paid.

Figure 4.20: enterprise value, equity value and asset value

The importance of valuations has increased for the industry as competition for new funds has grown. There is an incentive to inflate reported valuations in order to attract investors in new funds and there has been research and debate about whether this occurs and how to increase transparency and consistency between managers and investors to avoid it happening.

Equity value

Value of outstanding debt

Enterprise value

Goodwill

Net book value of assets


The International Private Equity and Venture Capital Board (IPEV) issued a set of international valuation guidelines in 2005 in an attempt to address the problems of inconsistent valuation methodology. These are periodically updated, the last occasion being in 2009.

These rules suggest that there are five main valuation methods (plus a sixth, that we call other). These are:

cost of last investment;

multiples; generally EBIT or EBITDA;

net assets;

discounted cash flows of the underlying business;

discounted cash flows of the investment; and

other industry valuation benchmarks.

Typically, investments are initially valued at cost and then move to a different valuation method as the investment matures. If the business is profitable (by which we mean it has at the date of the latest accounts, a positive EBITDA) it may be valued using a multiple. Conversely asset rich investments eg, real estate, may be valued on a net assets basis. Irrespective of the method adopted, the change in investment value in the early years after making an investment often reflects a change in method, not a change in the real underlying economics of the investment case. If a portfolio was all valued at cost in the first year of investment and then on EBITDA multiples, the change in portfolio value would be:

(Change in EBITDA multiple x change in EBITDA) + (Investments previously valued at cost now valued using EBITDA) (Cost of investments no longer valued at cost)

In practice, changes in valuation method post-buy-out may lead to apparent changes in value even without changes in multiples or profits. This is an area where care is needed in researching firm level returns. Generally studies have compared exit receipts to pre-exit valuations and found that the exits are generally at higher values than the pre-exit valuations. From this it is concluded that valuations are conservative. In fact this shows that valuations are conservative immediately prior to exit, it has less to say on the question that exercises limited partners (LPs): are interim valuations currently inflated to attract investment in new funds?

4.3.4 Latest valuation and performance data

As most funds are 10 year funds, any fund raised prior to around 2004/2005 will now have stopped investing in new companies, although it might be making follow-on investments in existing portfolio companies.

If we compare the valuation per 1 invested in each of the three surveys conducted by the BVCA, we obtain an indication of the rate at which distributions and valuations have moved over the period 20082010. It should be noted that this is work that is evolving and the samples, while materially the same, are not identical. The data suggests that for BVCA members who took part in the survey there were limited distributions over the period and the valuations of unrealised investments improved (Figures 4.21 and 4.22). This is perhaps not surprising given that the period covered began in 2008 in the aftermath of the liquidity crisis.


Figure 4.21: value per 1 invested in UK private equity firms distributed and undistributed value

source: BvCA/PwC 2010/2009/2008.

Figure 4.22: total return per 1 invested by vintage of fund

source: BvCA/PwC 2010/2009/2008.

The distribution of returns around the mean and the performance relative to other investments is of primary importance to any potential investor. Funds often refer to being in the upper quartile of investment returns, yet by definition not all funds can be in this category (Figure 4.23).

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Figure 4.23: Upper, lower quartile and median returns

source: BvCA/PwC.

The data indicate generally falling absolute returns. This could reflect falling absolute performance or conservative valuations in unrealised investments in the later vintages.

The data only show funds raised prior to 2006 and therefore should only include funds that are substantially invested. An analysis of the committed but uninvested funds, so-called dry powder, by vintage, shows that only 2005 and 2006 in this period have substantial uninvested commitments. This analysis shows the outstanding undrawn commitments at the end of 2010. As we discuss below, some investors have sought to reduce their commitments to funds that have not performed as anticipated.

When pure cash distributions are analysed, the data shows that the later funds on average have made zero distributions, and the inter-quartile range, a measure of the dispersion of the returns around the average is small; in essence the jury is still very much out (Figures 4.24 and 4.25).

Figure 4.24: range of returns distribution per 1 invested by vintage year since inception to december 2010

source BvCA/PwC.

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Figure 4.25: inter-quartile range by vintage to december 2010

source: Authors analysis of BvCA/PwC.

We have presented above a re-analysis of the BVCA/PWC data covering three year-ends from 20082010. We have illustrated that returns are slow to be finalised and that the trends are difficult to unpick due to the uncertainty surrounding the valuation of unrealised investments.

The long-term trend to the end of 2010 was for falling absolute returns but with significant variations around the median. The problem for investors in new funds is that the long-term nature of the commitment makes it very difficult to objectively discern which managers have an enduring track record. The data are simply too thin.

4.4 exits

4.4.1 A brief digression on the short-term/long-term debate

Realising investment value is the ultimate goal of any investment. In private equity this is in sharper relief than in many other asset classes because the investment is generally realised in a single transaction. This distinction sometimes gets lost in the discussions about short-termism and long-term investment.

All investors in equities seek to buy and sell periodically. Portfolio managers of quoted stocks and derivatives are often marketing their superior ability to pick winners and to trade in a wide variety of publicly quoted stocks and shares to potential investors. Private equity managers are not marketing any trading ability; they market stock picking and active management skills. It turns out from the academic research in this area that while private equity-backed companies are sold more frequently than companies that are quoted, the term that the private equity investors hold their investment is generally longer than the comparable term of investment managers holding shares in quoted companies. This is the essence of the short-term/long-term debate; critics concentrate on the frequency of change of control, while advocates compare and contrast the term of the investment and the long-term nature of carried interest as a reward.

In a sense both critics and advocates are right, but the real question is not how long or short a hold period is. The real economic question is how efficiently the people and assets of the business are deployed.

Ran

ge per 1

privateequity updated 2012 final

Documents

private equity industry

private equity sector

private equity investments

private equity transactions

confidence icaew

financing change programme

explanatory guide

restructuring industry