Private Equity. Critical analysis from the points of view of investors and target companies

Executive Summary

Private Equity plays an increasingly important role in the financing of a wide range of businesses. Over the past 20 years, private equity has been on of the fastest growing markets for corporate finance. One of the reasons the private equity industry exist is that, in many cases, companies have needs for capital which, for various reasons, cannot be met from the public markets. Investors that provide capital to private equity funds invest in an asset class that entails relatively high-risk and high illiquidity in what remains a largely unregulated market. Planning how to exit an investment is just as important as preparing to make one because a merger adds value only if synergy, better management, or other changes make the two firms worth more together than apart. The target companies are supported with accountants, lawyers, investment bankers and other specialists. Especially Start-up companies are often characterised by negative cash flows and demand high investments. PE gives the chance to reduce the financial gap between selffinancing and stock exchange listing and can also help to improve the equity ratio. Another advantage of PE for target companies is the increase of equity and an improved balance sheet structure. Regarding to that, the negotiating position is strengthened towards creditors, the credit rating is improved and the financial room for investments increases. The main disadvantage of PE for target companies is the weakened influence of the initial shareholders. Especially different strategically views between those two groups might be difficult to solve. Due to the fact of the high risk, from the investors’ perspective, PE is a very interesting form of investment. Especially under diversification aspects the investment in PE funds make sense, because the investors offer investment opportunities that can not be replicated in the financial market and on top of that have a low correlation with other asset class.

The firms standard practice of buying businesses and then, after steering them through a transition of rapid performance improvement and selling them is at the core of private equity’s success.

Table of Contents

Executive Summary ... II

Table of Contents ... III

List of Abbreviations ... IV

List of Figures ... V 1

1. Introduction ... 1
1.1 Objective ... 2
1.2 Methodology ... 2

2 Private Equity ... 3
2.1 Definition ... 3
2.2 Private Equity in Germany ... 7

3 Perspective of Target Companies ... 9
3.1 Advantages ... 9
3.2 Disadvantages ... 10

4 Perspective of PE investors’ ... 11
4.1 Why to invest ... 12
4.2 Exit Strategies ... 13
4.2.1 IPO ... 13
4.2.2 Trade Sale ... 14
4.2.3 Secondary Sales ... 15
4.2.4 Buy-back ... 15
4.2.5 Recapitalisation ... 16

5 Conclusion ... 17

Bibliographie ... 19

ITM-Checklist: 360-degrees analysis ... VII

List of Abbreviations

CEO Chief Executive Officer
e.g. ... exempli gratia
et. al. ... et alii
etc. ... et cetera
i.e. ... that is
IPO ... Initial Public Offering
KKR ... Kohlberg Kravis Roberts & Co.
M&A ... Merger and Acquisitions
p. ... page
PE ... Private Equity

List of Figures

Figure 1: Structure of Private Equity Investment vehicle ... 4
Figure 2: Alternative Investments: Private equity and hedge funds ... 5
Figure 3: PE investments in Germany since 2007 ... 7
Figure 4: PE-Investments in Europa 2012 ... 8
Figure 5: Average score on 18 management practice questions ... 17

1 Introduction

As the world emerges from one of the biggest financial crises in history, the list of causative factors for the global bubble that preceded it becomes clear. A lack of transparency in the investment markets; a rush to illiquid assets and a glorification of aggressive investment strategies are some of those factors. ¹ In recent years the profile of the private equity (PE) industry has increased dramatically. While the industry has been actively investing in companies across a wide range of industries for several decades, the combination of astute buying by PE funds focused on leveraged buyouts in the early part of the last decade and the extremely liquid credit markets of 2004-2007 fueled some impressive exits. ² This strategy of investment, which results in highly leveraged target companies after an acquisition, has been the subject of heated debate. A main criticism of this practice is the heavy burden of debt incurred by the acquired company, which supposedly lowers the scope for profitable investments. ³ While PE firms typically intend to sell the target company after a certain period of time, they are regarded as corporate raiders, striving for short-term profits at the cost of the long-term prospects of the acquired company and the well-being of its employees. ⁴

Considering this situation, the assignment critically analyses the target companies and the investors’ point of view when closing PE deals. The questions shall be answered what advantages and disadvantages, respectively difficulties, a PE investor and the target company might have. When does a deal become attractive for investors, and when for the target companies?

1.1 Objective

The assignment critically analyses the target companies and the investors’ point of view when closing PE deals. The questions what advantages and disadvantages a PE investor and the target company might have shall be answered as well as when does a deal become attractive for investors, and when for the target companies?

1.2 Methodology

Besides the introduction and the objectives in chapter one, the structure of this assignment bases on the explanation and definition of PE in chapter two. Although an overview of the German PE market is given. The third chapter is dedicated to the target companies’ point of view. Associated to that the advantages for the target companies’ as well as the possible disadvantages are revealed. In chapter four the investors’ point of view is explained. Therefore the different exit strategies of PE investors are displayed as well as the motivations of the investors. The fifth chapter provides conflicts and solutions to PE deals before the assignment closes with a conclusion in chapter six.

2 Private Equity

2.1 Definition

Private Equity (PE) is the name given to that part of the asset management industry where investments are made into securities. It is defined as a form of equity investment into private companies that are not quoted on a stock exchange. ⁵ PE is distinguished by its active investment model, in which it seeks to deliver operational improvements in its companies, over several years. ⁶ In addition there are more main characteristic of a PE funds which are listed as followed:

• A PE fund is a financial intermediary, meaning that it takes the investors’ capital and invests it directly in portfolio companies.
• A PE fund invests only in private companies. This means that once the investments are made, the companies cannot be immediately traded on a public exchange.
• A PE fund takes an active role in monitoring and helping the companies in its portfolio.
• A PE fund’s primary goal is to maximise its financial return by exiting investments through a sale or an initial public offering (IPO, see chapter 4.2 Exit Strategies). ⁷

The purpose of PE is to give companies access to fresh capital, that do not have access to the public capital market. Therefore PE is a possibility for companies to avoid bank loans or to complement them. ⁸ The typical private equity firm is organized as a partnership or limited liability corporation. Blackstone, Carlyle, and KKR are three of the most prominent private equity firms. ⁹ For example the Carlyle Group has approximately 600.000 employees worldwide. ¹⁰ The PE firm basically consists of a team of professional investment managers including a Fund Manager. The core roles of the Fund Managers are to provide the limited partnership with an investment management strategy and investment decisions. ¹¹ The major difference between private equity deals and other M&A activity is the involvement of the private equity firm in the transaction. ¹² Companies using PE financing can be in different stages of development. PE is mostly used in start-up companies, and firms that are experiencing a turnaround. ¹³ The invested capital in PE mainly comes from institutional investors such as pension funds, financial institutions, sovereign wealth funds or other stakeholders like board members (see figure 1). The investors can either make the investment directly e.g. in the case of a management buyout, or indirectly via a specialised PE company which is primarily used in the case of venture capital. ¹⁴

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Figure 1: Structure of Private Equity Investment vehicle (own figure, taken from: Talmor, E., Vasvari, F. (2011), p. 22.)¹⁵

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¹ Cf. Hobohm, D. (2010), p. 3.
² Cf. Talmor, E., Vasvari, F. (2011), p. 3.
³ Cf. Ernst et al. (2013), p. 181.
⁴ Cf. ebenda, p. 181.
⁵ Cf. Talmor, E., Vasvari, F. (2011), p. 4.
⁶ Cf. EVCA (2013).
⁷ Cf. Metrick, A., Yasuda, A. (2011), p. 621.
⁸ Cf. Pacher, A. (2011), p. 11.
⁹ Cf. Kaplan, S. N., Strömberg, P. (2009), p. 123.
¹⁰ Cf. Carlyle (2013).
¹¹ Cf. Heed, A. (2010), p. 29.
¹² Cf. ebenda, p. 29.
¹³ Cf. Talmor, E., Vasvari, F. (2011), p. 20.
¹⁴ Cf. ebenda, p. 21.
¹⁵ Cf. ebenda, p. 22.