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Overview of the Private Equity Sector Economics of Private Equity Investment

Center for the Study of Innovation and Productivity Federal Reserve Bank of San Francisco October 19, 2007
Colin C. Blaydon Professor of Management and Dean Emeritus Center for Private Equity and Entrepreneurship Tuck School of Business at Dartmouth
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Presentation objectives
Provide an overview of the role of Private Equity in the economy Explain the structure and history of the industry Describe the key participants and players Highlight forces that are shaping the industry

Center For Private Equity and Entrepreneurship 2007

What is Private Equity?


Narrow Definition: Equity investments in non-public companies
Key sub-sectors: o Venture capital focuses on investing in new companies with high growth rates o Buyouts the purchase of a controlling interest of a company or a business unit of a company by an outside investor often with substantial borrowed capital (in a leveraged buyout ) or a management team (in a management buyout)

Broad Definition: includes Private Investment in Pubic Equities (PIPEs), Mezzanine, Distress, Hedge
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Industry key players collaborate to make investments


Advisors: Gatekeepers Placement agents Other Service Providers: Consultants M&A advisors Underwriters Lawyers

Limited Partners
Pensions Endowments Foundations Wealthy individuals Other institutions

Private Equity Firms


Buyout

Venture capital

Portfolio Companies

Funds of Funds

Corporate Investors

Angel Investor s
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Funds flow back to LPs after liquidity events


Clawbacks Returned capital

M&A IPO

Limited Partners
Pensions Endowments Foundations Wealthy individuals
80% Profits Capital Invested

Private Equity Firms

Venture capital Buyout


20%

Entrepreneur s & Portfolio Companies

Cash / Shares

Transaction fees Profits Capital Invested Entrepreneurs Managers Other investors

100+%

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The private equity model


Concentrated governance
Small involved board Direct consultation Strong management incentive (ownership)

Absence of public market earnings myopia Source of value


Multiple expansion (buy low, sell high) Leverage Cash flow improvement

Iconic test: Chrysler and Cerberus


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Structure of a buyout: capitalization


Debt (~70% of overall cap structure)
Bank debt Two types:
Revolving credit facility (i.e. Revolver) can be paid down and

re-borrowed as needed
Term debt (senior and subordinated) w/ floating rates

Mezzanine debt Two types:


High yield (typically public markets) Subordinated notes (typically banks, institutions, private equity funds)

Other key features:


Warrants Payment-In-Kind (PIK) toggle allows no interest payment and increase in principal

Equity (~30% of overall cap structure)


Common stock Preferred stock

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The role of financial innovation and market structure


Impact of ERISA and the Prudent Man clause Junk bonds (1980s) Securitized debt: CLOs, CDOs (2000s) Pattern: correction
imitators excess and overshoot
dow n (rec cycle es defa sion, ults)
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innovation

and modification

The perfect storm


Economic recovery (2002+) Debt market expansion (2002 July 2007) LBO expansion (2003 July 2007) PE industry institutionalization (2006+) Confidence crisis and backlash

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Multiple expansion

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Debt market expansion


Expanding debt multiples Lower interest rates Vanishing terms Securitization (CLOs) Falling default rates

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Multiple expansion

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Leveraged loans outstanding

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Covenant-lite loans

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CLO structures become popular

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Default rates at historical lows


U.S. Corporate Market Default Rates
8.00% 7.00% 6.00% By Principal Amount By Number

Default Rate (%)

5.00% 4.00% 3.00% 2.00% 1.00% 0.00% Asian Contagion (Oct 97) Russian Default/ LTCM (Oct 98) Nasdaq Meltdown (Mar 00) Sept 11 (Oct 01) Adephia GM/Ford Liquidity Default Downgrades Squeeze (Oct 02) (May 05) (Sep 06) Subprime Contagion (July 07)

Source: Standard & Poors Leveraged Commentary & Data. As of August 2007.

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Rise of LBOs
Early returns (leveraged recaps for equity dividends) Expanding deal volume and size LBO fundraising expansion Club deals and mega deals PE industry institutionalization

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Quick dividend payouts

Source: Cambridge Associates

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Historical deal sizes


November-06 July-06 March-07 April-07 November-06 October-88 September-06 April-06 May-06 March-06 June-06 March-06 August-06 January-06 March-06 Equity Office HCA TXU First Data Clear Channel RJR Nabisco Freescale Semiconductors GMAC (Financing Unit) Kinder Morgan TDC AS Univision Communications SunGard Data Systems Royal Philips Elec. NXP Semi Conductor Business VNU NV GMAC Commercial Holdings Corp. (Mortgage Unit) $ 36.0 billion 33.0 31.8 29.0 26.7 25.1 17.6 14.0 13.6 12.9 12.1 11.0 10.5 9.7 9.0

Source: Buyouts, News Clipping, and Press Releases

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Deal size increases

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LBO deals expand


Global Financial Sponsor Buyouts
$450 $400 $350 US $ billions $300 $250 $200 $150 $100 $50 $0 2000 2001 U.S. 2002 Europe 2003 2004 2005 Other 2006 Asia-Pacific YTD 2007 (114) (82) (111) (150) (178) (338) (307) (annual aggregate) (740)

Source: Dealogic. *Acquisitions by private equity firms & add on transactions by portfolio companies. As of April 2007.

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Private equity fundraising increases

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Mega funds appear

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Largest funds of 2006 - 2007


FundManager GoldmanSac hs KKR Blac kstone TP G Carlyle Apollo ThomasH.Lee Hellman&Friedman BainCapital MadisonDe arborn Total Targe t Closed $10 .0BN $20 .0BN $15 .5BN $18 .5BN $13 .5BN $15 .6BN $14 .0BN $15 .2BN 17 .0BN $15 .0BN $10 .0BN $10 .1BN $9 .0BN $8 .0BN $8 .4BN $8 .0BN $8 .0BN $8 .0BN $10 .0BN $6 .5BN $ 115 .4BN $1 24.9BN

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Syndicates use purchasing power

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PE firms seek liquidity


LBO Firms Investor

Apollo. Credit Lyonnais Blackstone. Peoples Bank Of China The Carlyle Group Abu Dhabi Government Thomas H. Lee Partners. Putnam Investments/ Marsh & McLennan Fortress Investments......... Nomura Holdings Inc.
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PE goes public (IPOs)


Listing Date Type Market Cap*

NASDAQ

2004

Close-end debt fund Feeder to U.S.-based fund Sale of Management Company Sale of Management Company Feeder to U.S.-based fund Feeder to U.S.-based fund

$2.2BN $1.6BN

Euronext NYSE

2006

2007 2006 2006 2005

$7.3BN

NYSE Euronext Euronext

$2.2BN

$3.9BN Euro 1.1BN

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Evolution of PE firms: a new bulge bracket


Managing Multiple Funds
Apollo Advisors Bain Capital The Blackstone Group The Carlyle Group GS Capital Partners Hellman & Freidman JPMorgan Partners KKR Madison Dearborn Providence Equity Partners Silver Lake Partners Texas Pacific Group Thomas H. Lee Partners Welsh Carson Anderson & Stowe Warburg Pincus

Sold Minority Interest

Public Capital

Captive of Financial Institution

Independent Mono-Line Boutique

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Backlash, confidence crisis, correction


Backlash
Envy, ignorance, injustice Tax proposals Union activism

Confidence crisis
New mega deals hung up or on hold CLOs terminated or restructured

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Delayed or canceled leveraged loan transactions


B or ro w er ($ in m illio n s) C hrys ler - C a rC o Allis on T ra ns m iss io n U S F oo d Se rv ic e Serv ic e M a ste r C alp ine T arga R e so urces H om e D ep ot Su pply EP C O H old ings Bom bardier R ec reation P ro duc ts Borde r G roup U S In ves tigations Ev ra z O regon Ste el M ill Ente rp ris e G P H o ldings Sou rc e In terLin k Laurea te Ed uc atio n C ollec tiv e B ra nds T ow er Au tom otiv e H unt R efin ing M ye rs Ind us tries Vertrue D AE Av iat ion Integ ra BIS YS GS I G roup Intertap e Po lym er G roup R adN e t C C S M edica l Allia nt Ins uran ce D ayto n Su perior VN U Sym bion Ox yg en M edia Ston eridg e Eag le P ic her Stolle M ac hinery Orec k SG S I nternationa l Es co rt On eid a 39 D e als L o an am o u n t $10,0 00 $3,5 00 $3,4 65 $3,3 50 $3,0 00 $2,4 75 $2,2 00 $1,7 00 $1,4 00 $1,3 25 $1,2 55 $1,2 00 $1,2 00 $1,1 80 $1,1 50 $1,0 75 $9 10 $7 60 $6 85 $6 60 $6 57 $5 95 $5 65 $4 75 $4 60 $4 45 $4 30 $4 20 $4 10 $4 00 $3 75 $3 45 $3 00 $2 90 $2 50 $2 00 $1 94 $1 24 $1 20 $49,5 45 Pu rp o se LB O LB O LB O LB O R e fi D iv R eca p LB O R e fi D iv R eca p R e fi LB O R e fi R e fi A cq LB O A cq D ip E xit / LB O G CP LB O LB O A cq M &A LB O LB O LB O R e fi R e fi LB O R e fi A cq LB O R e fi R e fi R e fi D iv R eca p R e fi R e pric e D iv R eca p D iv R eca p D elayed / Pre -fu n d ed $ 10,00 0 $3,50 0 $3,46 5 $3,35 0 $ 3,000 $ 2,475 $2,20 0 $1,70 0 $ 1,400 $ 1,325 $1,25 5 $ 1,200 $1,20 0 $1,18 0 $1,15 0 $1,07 5 $91 0 $76 0 $68 5 $66 0 $65 7 $59 5 $56 5 $47 5 $460 $445 $430 $42 0 $41 0 $40 0 $37 5 $345 $300 $290 $250 $200 $194 $124 $120 $1 2,558 C a nc elled

Source: JP Morgan

$ 36,98 7

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Leveraged finance calendar is busy and uncertain


TXU (KKR/TPG/GSCP) BCE (Ontario/Providence/M DP) Alltel (TPG/GSCP) Clear Channel (THLee/Bain) Basell (N/A) First Data (KKR) Sallie M ae (JCFlowers/JPM /BoA) Harrah's (Apollo/TPG) Cablevision (Dolan family) Hexion Specialty Chemicals (Apollo) Intelsat (BC Partners) Chrysler Car Co (Cerberus) M ylan Labs (N/A) Home Depot Supply (Bain/Carlyle/CD&R) Penn National Gaming (Fortress/Centerbridge) Alliance Data (Blackstone) ACS (Cerberus/Darwin Deason) United Rental (Cerberus) Avaya (TPG/Silver Lake)
$0.0
$ 4.4 $ 4.1 $ 2.5 $ 4.3 $ 4.9 $ 3.4 $ 7.1 $ 2.2 $ 2.5 $ 4.0 $1 .7 $ 9.0 $ 7.3 $ 6.0 $ 5.1 $1 0.0 $ 2.9 $ 3.8 $ 7.8 $ 7.2 $ 7.1 $ 6.6 $ 6.6 $ 6.5 $ 6.0 $ 6.0 $ 5.1 $ 6.2 $1 2.0 $1 0.2 $1 0.0 $ 8.0 $1 2.5 $ 6.0 $1 3.5 $1 4.0 $ 9.0 $ 4.0 $1 5.0 $1 5.5 $1 8.5 $ 7.0 $1 7.0 $1 6.5 $ 26.1 $ 23.1 $ 7.7 $ 2.6 $ 21 .1 $ 21 .0 $ 23.2 $1 2.4 $ 1 .3 1 $ 35.5 $ 37.4

Loan

Bond

$5.0

$10.0

$15.0

$20.0

$25.0

$30.0

$35.0

$40.0

Source: JP Morgan Center For Private Equity and Entrepreneurship 2007 31

Correction
PIK toggle debt disappears Covenants reappear Debt and enterprise value multiples decline Bank senior debt reappears Debt interest rates rise

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Covenant light transactions that add covenants


Borrower Aeroflex Alliant Insurance Appleseeds Caritor CDW Ceva Logistics Chrysler - Fin Co Chrysler - Car Co Container Store Express First Data Good Year EPD Gregg Appliances Harlan Sprague Dawley Hilite International Investive Medical Media Mitel Networks Myers Industries Nelson Education Niagara RJ O' Brien Source Interlink Spirit Finance Syniverse Thomson Learning Tower Automotive Van Houtte Vertrue MorganWhite Birch Recent selected maintenance covenant - flexed loans Sponsor Covenant Addition Veritas Capital, Golden Gate Capital Total Leverage Test Blackstone Sr. Sec. Leveraged Test Golden Gate Capital 1st lien Leverage Test/ Minimum EBITDA CVCI Net Leverage Test Madison Dearborn Sr. Sec. Leveraged Test Apollo Sr. Sec. Leveraged Test Cerberus Debt to Net Worth Test to include 2nd lien Cerberus Borrowing Base Test / Minimum Liquidity Test Leonard Green Rent Adjusted Sr. Sec. Leverage Test Golden Gate Capital Leverage Test KKR Sr. Sec. Net Leverage Test Carlyle Sr. Sec. Leverage Test Freeman Sogli Leverage Test Genstar Investment Group Maintenance Test Kelso, Blue Capital, Court Square Capital Interst Coverage Test / Leverage Test NA Total Leverage Test Providence Ventures Leverage Test Morgan Stanley Capital, Francisco Partners Maintenance Test Goldman Sachs Leverage Test OMERS Capital Partners 1st lien Leverage Test/ Total Leverage Test Kohlberg & Co. Leverage Test Spectrum Equity Investors Total Leverage Test Yucaipa Companies Sr. Sec. Leverage Test Macquarie / Och - Ziff Loan to Value Test / Debt Service Coverage GTCR Golder Rauner Maintenance Test Apax, OMERS Capital Partners Sr. Sec. Leverage Test Cerberus Interst Coverage Test / Net 1st and 2nd lien Leverage Test Littlejohn & Co Total Leverage Test One Equity Partners 1st and 2nd lien Leverage Test NA Interest Coverage Test

Source: JP

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Vulture and special situation funds raised overnight


The potential returns on LBO debt at the moment match those of equity investments in the buyouts.
-Blackstones Q2 earnings call

Goldman Sachs - Market Dislocation Fund Lehman Brothers - Special Situation Fund Oak Tree Capital - Special Situation Fund TCW - Special Mortgage Credit Fund Ellington Management - Vulture Fund Marathon Asset Management - Vulture Fund
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Credit crunch impact on LBOs

Some 29 buyout-backed companies with an estimated $17.3 billion in publicly-traded debt are at high risk of defaulting on those obligations, according to a new report from ratings agency Standard & Poor's.
Buyouts Magazine Sept. 2007

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Outlook for private equity


New mega deals on hold Recent mega deal expected returns diminished M&A auction hierarchy shift
PE owned strategic acquirer Stand-alone financial buyer Traditional corporate strategic acquirer

Restructuring of CLO market terms Minority private investments Private investments in public equities (PIPEs) Defaults and distressed investing cycle (S&P)?
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