PRIVATE EQUITY

Private Equity

Private equity investment funds have a fixed term that is typically ten years with possible one to two year extensions.
These agreements should ensure that appropriate long-term frameworks, boundaries and alignment of interests are in place.

The most common legal structure for private equity funds is the limited partnership. The name refers to the limited liability of the providers of capital, called the limited partners or LPs. The investment manager is the general partner or GP. The partnership is governed by a limited partnership agreement (LPA) negotiated and signed by the parties involved.

Agency Relationship- LP & GP

CARROT

Reputation of GP affects future fund raising ability GP compensation based on fund raising ability
STICK

Covenants of the partnership agreement place boundaries on what the GP can do an provide LP intervention in extreme cirumstances Advisory boards (including LP representation) provide direct oversight over GP decisions

Agency Relationship- PE Firm & Portfolio Companies

CARROT Managerial ownership of company shares ensures a long-term interest in company performance Managerial compensation tied to company performance

STICK PE firm generally takes a board seat and can gain added seats if performance of the portfolio company falters PE firm has a control portfolio companys access to additional financing.

Private Vs Public Equity Investing

PE investors make illiquid investments PE investors are active (role in the management) PE investment Finite Period PE investments are risky & hence expects high return

Market for PE- Investors

Corporate Pension Funds Public Pension Funds Endowment Insurance Companies Wealthy Family & Individual Investment Banks Other Investors

Market for PE Intermediaries

PE Firms

Managed by independent partnership organizations

Managed by affiliates of financial institutions

Market for PE - Issuers

Companies receiving PE capital

New Ventures

Early Stage Later Stage Growth or expansion capital Change of capital structure Consolidation capital Restructuring Capital

Middle Market

Public Companies

Categories of PE Investments

Seed & Start-up capital

Typically provided angel investors For developing a concept, create the initial product and carry out first marketing efforts. Typically the company seeking funds are less than a year

First Stage Capital

For developing a proven product, to start commercial production and marketing Typically the earliest stage a VC will invest

Second Stage Capital

Capital provided to expand marketing and meet the growing working capital needs The target firm has commenced production but does not have sufficient cash flows from its operations to fund its capital needs

Expansion Capital

The capital needed to fund the expansion of a profitable firms operations where the growing firm is incapable of generating sufficient earnings internally.

Bridge Capital

A short-term loan that provides needed capital while the borrower arranges for more comprehensive longer-term financing.

Mezzanine Capital

Unsecured, high-yield, subordinated debt or preferred stock that represents a claim on a companys assets that is only senior to that of a companys share holders.

Typical Rate of Returns

Investment Seed First Stage Second Stage Expansion Bridge&Mezzn

Return 50-100% 40-60% 30-40% 20-30% 20-30%

Period >10 yrs 5-10 4-7 3-5 1-3

Structuring a Deal

Term Sheets
Brief preliminary documents designed to facilitate and provide a framework for negotiations between investors and entrepreneurs. A term sheet generally focuses on a given enterprises valuation and the conditions under which investors agree to provide financing. The term sheet eventually forms the basis of several formal agreements including the Stock Purchase Agreement, which is a legal document that details who is buying what from whom, at what price, and when.

Common types of Securities used in venture capital transactions

Common stock is a type of security representing ownership rights in a company. Common stock is generally not convertible into any other type of security. Convertible preferred stock provides its owner with the right to convert to common shares of stock. Usually, preferred stock has certain rights that common stock does not have, such as a specified dividend that normally accrues and senior priority in receiving proceeds from a sale or liquidation of the company.

Redeemable preferred stock can be redeemed for face value at the choice of the investor. Sometimes called straight preferred, it cannot be converted into common stock. Usually, the terms of the issue specify when the stock must be redeemed, such as after an IPO or a specific time period. Redeemable preferred gives the investor an exit vehicle should an IPO or sale of the company not materialize.

Convertible debt is a loan vehicle that allows the lender to exchange the debt for common shares in a company at a preset conversion ratio. Mezzanine debt is a layer of financing that often has lower priority than senior debt but usually has a higher interest rate and often includes warrants.

Senior debt is a loan that enjoys higher priority than other loans or equity stock in case of a liquidation of the asset or company.

Subordinated debt is a loan that has a lower priority than a senior loan in case of a liquidation of the asset or company.

Warrants are derivative securities that give the holder the right to purchase shares in a company at a pre-determined price. Typically, warrants are issued concurrently with preferred stock or bonds in order to increase the appeal of the stock or bonds to potential investors. They may also be used to compensate early investors for increased risk.

Options are rights to purchase or sell shares of stock at a specific price within a specific period of time. Stock purchase options are commonly used as long-term incentive compensation for employees and management.

Valuation Methodologies

Traditional DCF

Optimistic or hoped-for DCF valuation approach

Valuation Methodology

The investor first determines a rate of return that he or she hopes to realize from the investment.
Investors required rate of return is used to determine the value the investor hopes to realize at the end of the planned holding period

Investor estimates the value of the firms equity at the end of the holding period (Year H) using a multiple of the firms projected EBITDA in year H.

Investor calculates the fraction of the firms future value that will be needed to satisfy his/her total required return (i.e initial investment compounded at the investors hoped-for rate of return over the investment period)

Pre-and-Post Money Value of the Firms Equity

Post-Money Investment Value

Implied Value of the Equity of the firm today

Pre-Money Investment Value

Difference between the post-money implied value of the firms equity and the amount of money that the VC puts in the firm.

Refining the Deal Structure

Staged Financing

Issuing a different type of a security (e.g preferred stock as compared to common stock)

Exit Strategies

A merger with another company, either public or private An acquisition by another company, either public or private An Initial Public Offering A Private Placement, whereby the company sells its securities to accredited or institutional investors.

Common motives behind the pursuit of a merger or acquisition

Strategic: the target company has a technology or service that the acquirer cannot or will not build or develop on its own. Defensive: the target company offers too much competition or is stealing too much market share from the acquirer. Financial: the purchasing entity needs the target company to strengthen its financial statements. Growth: a financial conglomerate has the capital, a well-developed distribution network, and certain expertise to further develop an existing company.

Some Hurdles for PE Investment In India

Governance rights: When private equity investors acquire rights in listed companies (such as veto rights on key decisions), there is a possibility that they may acquire control over the company thereby triggering public offer requirements under the SEBI Takeover Regulations. This primarily arises because of an expansive interpretation of the term control that has been adopted by SEBI.

Lack of flexibility on convertible instruments: A popular instrument used for private equity in the past was convertible preference shares. However, since May 2007, preference shares with a conversion option requires onerous approvals for investment.

Lack of the ability of private equity funds to carry out due diligence inability of private equity (or other) investors to carry out leveraged transactions (which involve leveraging the assets of the target company) in India

PE/VC & Indian Industry Bharti

Warburg Pincus Investment in Bharti over a period of 2 years USD 300 million Funds came with strategic support Included a strategic JV with singapore telecom & multibillion dollar outsourcing technology with IBM.

Air Deccan

Investors ICICI Ventures & Capital International Objective To build capacity in a phased manner Seeking capital for growth, Air Deccan obtained PE investment from ICICI Ventures, which invested USD 30 million in 2004 for a 19 percent equity share

The PE investment in Air Deccan brought both operational and fiscal discipline. PE firms helped setup a proper organisation structure and created a formal business plan. The financing enabled Air Deccan to pursue its aggressive business model of running a budget airline

Meru Taxi

The PE firm, IVF, invested INR 2 billion in VLink in 2006, and took a majority holding, enabling the introduction of the Meru brand. Apart from enabling scale, IVF brought in professionals. IVF facilitated the recruitment process, attracting high-end talent from reputed companies, including global organisations. It also created the franchising model based on a study of similar systems globally, focused on air-conditioned cabs fitted with high technology, including data terminals and GPS systems in each Meru cab. IVF also helped V-Link raise debt to purchase vehicles, standing in as guarantor