Excerpt
Table of Contents
List of Figures
List of Abbreviations
1. Introduction
1.1 Problem and Objective
1.2 Scope of Work
2. Fundamentals of Private Equity investments
2.1 Definition and Product Categories of Private Equity
2.2 The Structure of Private Equity Business
2.3 The Origin and History of Private Equity Market in Germany
3. Process of Private Equity Investments and Negotiation Criteria
3.1 Planning Phase
3.2 Due Diligence
3.3 Final negotiation and Sales Contract
4. Exit Strategies
4.1 Trade Sale
4.2 Secondary Sale
4.3 Buy back
4.4 Initial Public Offering (IPO)
5. Risks and Opportunities of Private Equity Investment
5.1 Critical Analysis from the Company´s Point of View
5.2 Critical Analysis from the Investor´s Point of View
6. Outlook and Conclusion
Bibliography
List of Figures
Figure 1: Corporate Value Calculation Methods
Figure 2: Essential Contents of Memorandum of Understanding
Figure 3: The Main Exit Strategies
List of Abbreviations
Abbildung in dieser Leseprobe nicht enthalten
1. Introduction
1.1 Problem and Objective
In the last decades, the private equity (PE) market in Germany has witnessed waves of rise and fall. But it surpassed, by the end of 2017, all the records of German PE history. According to Deutsche Beteiligungs (DBAG), the amount of transactions in the mid-sized businesses in the German market dramatically increased and hit €4.4 billion in 2017 which was the highest during the last 15 years.1 But in contrast, the competition in the German market has been recently high with a steady number of companies which led to high prices and overvalued companies. PE firms target the mid-sized businesses since they are more likely to accept financial investors than bank loans or credit lines. However, this problem can now be countered with the help of PE in the context of alternative corporate financing. It should be noted that PE business has been a concern of German politics and businesses since the 1960s where the financial system was basically based on banks which is not appropriate for the development of PE industry. The government intervention was the base to build a stronger PE industry away from bank-based financial systems. Recently, the stock market segment was a key driver for the dynamic development of PE market. The price falls and the collapse of the overheated and overvalued companies were also clearly felt in the PE segment and generated a great deal over scepticism on the capital markets.
1.2 Scope of Work
This work focus on the PE investments within SMEs. Fundamentals of private equity investments are reviewed in the second chapter. This includes definition and product categories of private equity and how PE business is organized as well as the history of PE market in Germany. The third chapter analyses the process of the PE deals including the different phases as well as the exit strategies. The last chapter critically analyse the PE deals from the point of view of the investor and the targeted company before closing with the outlook and conclusion.
2. Fundamentals of Private Equity investments
2.1 Definition and Product Categories of Private Equity
According to the European Private Equity & Venture Capital Association (EVCA), private equity can be defined as “equity capital provided to enterprises not quoted on a stock market”.2 The term PE is often described in today's literature as "non-exchange-traded-equity" where PE companies invest in the equity capital of companies not listed in the stock market aiming to finance the growth of small and medium-sized enterprises (SMEs) with externally sourced equity.3
The term that still often appears as a synonym for PE is Venture Capital. But according to the official definitions of the two PE umbrella organizations - BVK and EVCA - PE is the generic term, while venture capital is a product category of PE. Venture capital is basically used in the early stages of corporate development as well as in other expansions and based on return expectations from the value growth of the company.4 This also includes active, entrepreneurial support for the financed company since the risks and deficits are particularly high in the early stages. Another category of PE is the so-called Buyout financing into established companies. This category includes leveraged Buyout (LBO) to fund growth, support businesses in turnaround situations or as a spin-off financing of parts of the Group and Management Buyout (MBO) to fund the management team of the financed company to acquire part or all of the business.5 In addition, in the PE market, the so-called Mezzanine financing is a hybrid financial instrument between equity and debt.6 The mezzanine entitles the PE firm to convert to an ownership or equity interest in the financed company in case of default. Hence, these PE categories provide an alternative financing for all stages of a company's development.
2.2 The Structure of Private Equity Business
The PE business is typically organized as limited partners (“LPs”) and general partners (“GPs”). LPs constitute the outside investors providing the capital as institutional investors such as insurance companies, endowment funds, banks, foundations, pension funds as well as high-net-worth individuals.7 The majority of PE funds are organized as LPs where the liability extends only to the amount of contributed capital and normally for a lifetime of 10 years. GPs are the professional investors who make “capital calls” when needed and deploy the pool of fund´s capital.8 They manage the capital and all stages of investment cycle in terms of deal sourcing and origination, making investment decisions, transaction structuring, portfolio management and exit strategies. Today in the German PE market, there are two most common structures, the Limited Liability Company (GmbH) and the Limited Partnership (KG) with a sole general partner (GmbH) in the legal form (GmbH & Co. KG).9
The PE firm aims at increasing the value of the financed company through a supervisory, advisory and management support. The target group of PE companies are thus companies with an above-average potential for value appreciation, through innovative products or efficient restructuring. After the value having been increased, the PE firm will thus be able to resell the holdings held for a certain period of time at a profit. Hence, it can be said that the business of the PE firms consists of the purchase, management and sale of equity interests. In doing so, companies are financed and also supported by business management, which helps the company in its development and is reflected in the company value. Of course, this last described process is an optimal case, which does not always happen in reality.
2.3 The Origin and History of Private Equity Market in Germany
The idea of equity capital, and above all of venture capital (VC), originated in the USA. Capital for innovative and risky endeavour was indeed awarded before the Second World War. The whole thing began in 1946 in an institutionalized form. The literature therefore unanimously agreed on the American Research and Development Corporation (ARD) as the first VC company.10 The beginnings of the German equity capital market back to the mid-1960s, when the first PE company, Deutsche Beteiligungsgesellschaft (DBAG), was founded as VC firm providing funds to companies not publicly listed.11 Until the mid-1970s subdued development of this new stage of the capital market was due to various German characteristics. For one thing, the German market lacked the large pension funds as institutional investors and was falling behind the US, UK and France in technological innovations. Secondly, there was no market in Germany for a long time, which made it easy to exit. The third striking peculiarity in the context of corporate financing in Germany is the intensive house-bank relationships of companies, which did not turn out to be particularly open and encouraging for this new form of financing.12 The 1970s were characterized by the medium-sized investment firms, which could refinance favourably by the ERP investment program launched by the Government. However, the intention to promote the mid-sized companies by this did not achieve promised success, since the restrictions associated with the program made it unattractive to PE firms.13 With the beginning of the 80s, a new wave of foundations set in, this had its focus on the venture capital area and wanted to copy the American model of success. But even here, the successes were not to the extent that they were observed in the American market. This was partly because the start-up and technology landscape in Germany were not as advanced as in the US. Another reason is the non-existent divestment opportunities which hindered the attractiveness of equity financing. Nevertheless, the PE market recorded a boom at the end of the 1980s, but it came to a standstill at the beginning of the 1990s. Towards the end of the 90s, a true success story developed as will be reviewed in the next chapter.
3. Process of Private Equity Investments and Negotiation Criteria
PE investments go through three phases starting with planning phase then due diligence and the last phase is the sale contract phase as will be reviewed in the following sub-chapters.
3.1 Planning Phase
In this phase, the owner of the targeted company considers many factors in order to find the right investor as the following:
- The number of shares that should be sold to the PE company
- Sites and workplace whether it should be included in the contract
- Other parts of the business which don´t constitute the core business
- The value of the company or in other words the selling price
After these factors are determined, the owner can decide if the buyer is suitable or at least he can find the suitable one.14 The company valuation is usually made by external consultants or experts with know-how experience and can support the whole investment process. They also have contact with potential buyers and can help finding the most suitable one.15 However, the last decision is made by the targeted company which decides who to proceed with.
3.2 Due Diligence
Due diligence phase starts when the potential buyer has been defined by the target company. In this phase, the investor of PE company demands all the essential information needed about the targeted company with the help of advisors regarding legal, commercial, fiscal and financial aspects.16 The legal Due diligence are necessary to ensure the best possible agreements and review historical ones. The investor makes his own assessment according to the financial figures he gathered to determine how high the corporate value is.17 The calculation of the value can be outsourced or made in-house by different methods and according to different approaches such as income, economic profit, market and net asset approach as shown in figure 1 which illustrates the most important methods.18 The financial figure are also usually used to determine the unique selling point of the targeted company. Further, technical experts could be hired for technical due Diligence. The final due diligence is the management usually conducted by HR consultants. Hence, it can be said that due diligence process aims at minimizing potential risks.
Figure 1: Corporate Value Calculation Methods
Abbildung in dieser Leseprobe nicht enthalten
Source: Own depiction according to Massari et al., Corporate Valuation, 2016, p. 2.
3.3 Final negotiation and Sales Contract
As long as no disruptive information has been discovered that ends the deal, the negotiations start according to the outcome of the due diligence. During the due diligence process, new information that affect the valuation and assessments could occur and makes the investor reconsider terms, conditions and price. Before starting the final negotiations, both parties sign a Memorandum. In this document many essential points related to the purchase are included as shown in figure 2.19 In addition the document includes the points discussed in the meetings.20 All the negotiations revolves around the corporate value which is crucial besides other discussions about what to be sold including warranties and obligations of the entrepreneur.21 Usually, there is competition between many buyers and the owner of the targeted company should decide which buyer will take the investment where the latter should provide financing confirmation.22 In the final negotiation which precede the holding period the investor manages toward his set of goals preferred exit.
In the last contracting phase, the committee or board approval is necessary. Prior to signing the final contract, a draft of the contract is issued including all assets or shares taking into account warranties and guarantees.23 This draft is to assure accuracy of all documents and the enterprise ownership of all assets sold.24
Figure 2: Essential Contents of Memorandum of Understanding
Abbildung in dieser Leseprobe nicht enthalten
Source: Own depiction according to Jansen, 2008, p. 275
Furthermore, all rights that secure the investor from risks are included in the contract such as delegation and information rights as well as the exit arrangements.25 The Exit arrangements allow the investor to sell the enterprise after a period of time with the right to sell even earlier. The investor has also the so called “Right of First Refusal” which grants priority to the investor for buying other shareholders´ shares against other interested parties, otherwise it requires approval from the investor.26 Since the management team of the target company constitute a good source for the investor, the so called “Leaver Clause” is usually included in the contract where investor has the right to buy the shares of managers willing to leave the enterprise.27 But in this case, good and bad leavers are differentiated. Good leavers are managers leaving due to their bad behavior (conviction, insolvency, etc.). Good leavers are managers leaving in good will. The differentiation influences the share price where shares of good leavers are sold on market value basis and shares of bad leavers have lower value.28 Further, the “Tag Along Rights” ensure that other shareholders must sell their shares when the investor does while the “Drag Along Rights” allow the investor to sell his shares if other a shareholder does.29 In terms of only two shareholders exist, the “Mandatory Buy-Sell Clause” ensures the only one shareholder after the transfer where one must sell his shares to the other.30 During the time between signing and closing the contract, there should no significant change occur otherwise the investor has the right to cancel the whole process. Moreover, the registration right ensures that the investor even with minority shares can decide if the enterprise can go public.31
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1 Cf. Köhler P., Prices High, Investors Grumpy in German Private Equity, 2018, n. p.
2 Klier O. D., Managing Diversified Portfolios, 2009, p. 54.
3 Cf. Kokalj L.,Pfaffenholz G.,Moog P., 2003, p. 11.
4 Cf. Kokalj L.,Pfaffenholz G.,Moog P., 2003, p. 13.
5 Cf. Klier O. D., Managing Diversified Portfolios, 2009, p. 61.
6 Cf. Nijs L., Mezzanine Financing, 2014, p. 10.
7 Cf. Cornelius P., International Investments in Private Equity, 2011, p. 19.
8 Cf. Cornelius P., International Investments in Private Equity, 2011, p. 20.
9 Cf. Cornelius P., International Investments in Private Equity, 2011, p. 45.
10 Cf. Gaida M., Venture Capital in Deutschland und den USA, 2002, p. 31.
11 Cf. Frommann H., Dahmann A., Zur Rolle von PE und VC in der Wirtschaft, 2005, p. 12
12 Cf. Gaida M., Venture Capital in Deutschland und den USA, 2002, p. 191
13 Cf. Frommann H., Dahmann A., Zur Rolle von PE und VC in der Wirtschaft, 2005 p. 12.
14 Cf. Wegmann, J., Unternehmensverkauf, 2013, p. 59.
15 Cf. Böhm, O., Unternehmensnachfolge, 2015, p. 200.
16 Cf. Reuther, K.; Konrad, V., Unternehmensverkauf, 2012, p. 1.
17 Cf. Wegmann, J., Unternehmensverkauf, 2013, p. 114.
18 Cf. Massari, M.; Gianfrate, G.; Zanetti, L., Corporate Valuation, 2016, p. 2.
19 Cf. Jansen, Mergers & Acquisitions, 2008, p. 275.
20 Cf. Wegmann, J., Unternehmensverkauf, 2013, p. 131.
21 Cf. Böhm, O., Unternehmensnachfolge, 2015, p. 200.
22 Cf. Wegmann, J., Unternehmensverkauf, 2013, p. 137.
23 Cf. Wegmann, J., Unternehmensverkauf, 2013, p. 146.
24 Cf. Jansen, S. A., Mergers & Acquisitions, 2008, p. 316.
25 Cf. KPMG, Private equity, 2012, p. 14.
26 Cf. Bollefer, S.; Bernstein, J., Agreements, 2009, p. 18.
27 Cf. Draxler, J., Private Equity, 2010, p. 125.
28 Cf. Bergau, Unternehmenskauf, 2015, p. 483.
29 Cf. KPMG, Private equity, 2012, p. 14.
30 Cf. Draxler, J., Private Equity, 2010, p. 136.
31 Cf. Draxler, J., Private Equity, 2010, p. 146.