private equity an overview clark l. maxam, ph.d. director of research – braddock financial...
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Private EquityAn Overview
Clark L. Maxam, Ph.D.Director of Research – Braddock Financial Corporation
andEl Pomar Professor of Entrepreneurial Finance – University of Colorado,
Colorado Springs
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Private Equity – Broadly Defined
• Technically refers to any type of equity investment in an asset in which the equity is not freely tradable on a public market.
• Less liquid• Long Term in nature
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Private Equity – Categories and Players
• Angel– Early Stage: Seed, Start-up
• Professional Venture Capital– Early Stage, Expansion, Later Stage
• Private Equity– Later Stage, Buyout, Special Situations
• Hedge Funds– All Stages
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The Private Equity Market
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Venture Capital
Private Equity Hedge Funds
Angel
Key Player Overlap
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Traditional Private Equity – Primary Activity
• Professional pools of capital that buy all the publicly traded equity of target companies = “Go Private”
• Usually done with borrowed money– High degree of leverage
• Aka : Leveraged Buyout
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The Basic Value Creation FormulaFundamental Ideas
1) Re-focuses acquired businesses resulting in lower costs and improved efficiency.
2) Value is created through basic finance that says debt can increase firm value if you can afford it!
• Exploits corporate aversion to debt (Henry McVey, Morgan Stanley).
3) Regulatory Arbitrage – Sarbanes-Oxley
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The Basic Value Creation FormulaDebt can increase Value
Dupont Equation
Equity
AssetsTotalX
AssetsTotal
SalesX
Sales
NI
Equity
NIROE
Leverage – Debt as % of Assets Equity Multiplier ROE
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The Basic Value Creation FormulaDebt can increase Value
ROEEquity
AssetsTotalX
AssetsTotal
SalesX
Sales
NI
%16100
16
100
100
100
160
160
16XX
Consider a company that takes on debt at a cost of $3 in Net Income, but changes NOTHING ELSE.
Could drop NI to 4.8 and still match the previous ROE!!
%4030
12
30
100
100
160
160
12XX
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The Basic Value Creation FormulaAn Example – Carlyle Group
Leveraged Buyout
Case 1 (5 years) – No Profit Increase Case 2 (5 years) – Profit Increase
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Source: International Financial Services
Regional Breakdown of Private Equity InvestmentsFunds Raised
69%52%
17%38%
7% 8%7% 2%
0.00%
20.00%
40.00%
60.00%
80.00%
100.00%
2000 2005
North America Europe Asia/Pacific Other
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Source: International Financial Services
Private Equity Investments by Country
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Source: National Venture Capital Association,Thomson Venture Economics
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Source: National Venture Capital Association,Thomson
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Source: Cambridge Associates, LLC
Cambridge Associates U.S. Private Equity Index (period ending 9/30/2006)
0
5
10
15
20
25
30
35
1Yr
2Yr
3Yr
4Yr
5Yr
6Yr
7Yr
8Yr
9Yr
10Y
r
11Y
r
12Y
r
13Y
r
14Y
r
15Y
r
16Y
r
17Y
r
18Y
r
19Y
r
20Y
r
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• PE as a new Model of General Management (Jensen) – Overcomes entrenched thinking, management and
disjoint between manager incentives and capital markets.
– Problematic Trends• Publicly held Private Equity – oxymoron• Fee Structures not tied to exit • Hedge funds in the PE business – not a transaction
business.
Private Equity Issues Going Forward
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• 2007 estimate of$160B in dry powder $750B $590B in debt appetite.– Banking capacity is finite and already
extended.– Potential regulatory limits
Private Equity Issues Going Forward
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• PE Boom has been fueled by– Historically low rates– Regulatory arbitrage
• Both could reverse quickly and change the metrics dramatically
Private Equity Issues Going Forward