Critical analysis of private equity investments in SME


Term Paper, 2019

31 Pages, Grade: 2,0


Excerpt

Table of Contents

Executive Summary

List of Abbreviations

List of Figures

1 Introduction
1.1 Problem and objective
1.2 Scope of work

2 Fundamentals and theoretical basis
2.1 Definition of private equity
2.2 Definition of SME

3 Description and analysis of actual problem

4 Critical analysis
4.1 Introduction to the investment of PE
4.2 Leveraged buyout
4.3 Risk Characteristics of Private Equity
4.4 Rules, regulations and contractual infrastructure

5 Conclusion and outlook

Bibliography

ITM Checklist

Executive Summary

Is it worth the time and work involved in taking various risks and sometimes the path into the unknown? This question arises in the context with private equity financing. However, this is also a question which arises in companies when it comes to identifying a source of finance. No matter for what reason the company needs a financial injection, either for internal development, new production machinery or for a breakthrough into new markets.

In order to find out more about private equity, the assignments objective for the module “International Investment & Controlling” addresses the topic:

“Critical analysis of private equity investments in SME ”

For this purpose, this assignment will start with a short introduction on the relevance of the topic, followed by the fundamentals and theoretical basis of private equity as well as about SME’s. Furthermore, the actual problematic situation which belongs to private equity investments is presented. After these introducing topics the paper switches to its main part, the critical analysis about

- Investment done by GP / LP and a return increase
- Leveraged buyouts
- Risks characteristics
- Rules, regulations & contractual infrastructure

Finally, a conclusion as well as a critical outlook are provided. This conclusion contains that both, investors and companies, want to have a clearer view about risks and contractual requirements and restrictions.

List of Abbreviations

AIFMD Alternative Investment Fund Managers Directive

AWU Annual work unit

CVC CVC Capital Partners

EBITDA Earnings before interest, taxes, depreciation and amortization

EV Enterprise value

FCF Free cash flow

IPO Initial public offering

GDP Gross domestic product

KPI Key performance indicator

MBI Management Buy-In

MBO Management Buy-Out

Mio Million

PE Private Equity

PEPI Private Equity Performance Index

SME Small and Medium-sized Enterprises

TVPI Total value to paid-in capital

List of Figures

Figure 1: Value of private equity deals worldwide from 2013 to 2018

Figure 2: Definition of SMEs

Figure 3: Number of SMEs vs. amount of enterprises in Germany

Figure 4: Four mainly risks in PE investments

1 Introduction

1.1 Problem and objective

This assignment is intended to address the issue of "Critical analysis of private equity investments in SME" and examine various aspects related to private equity and SME. In the following, a practical reference will be made and the procedure will be explained later.

In April 2013, a German company was able to demonstrate the advantages of a private equity financing and to make a very successful IPO. The special aspect of this IPO was that the company did not choose a traditional, public way of IPO, but offered the shares to private investors in three steps. Following its IPO, the specialty chemicals company Evonik had a company value of €15.4 billion and a market capitalization of €2.2 billion, which puts it on a par with giants such as Adidas and RWE. The company owes this enormously successful stock market launch among other things to the private Luxembourg financial investor CVC, one of the ten largest private investors. When the chemical company went public, the RAG Foundation owned approx. 68%, 14% were owned by the private equity financier CVC and the remaining 14% in free float. The reason why Evonik did not choose the traditional route of a public IPO, but sold the majority of its shares to private investors, is explained by the fact that three of the company's IPOs, which were attempted in the traditional way, had previously failed.1 However, Evonik is only one example that private equity can be promising for many companies. Figure 1 shows the value of private equity deals worldwide. The increase in the value of private equity deals worldwide from 2013 shows how present private equity financing is at present.

Figure 1: Value of private equity deals worldwide from 2013 to 2018

Abbildung in dieser Leseprobe nicht enthalten

Source: Own figure in accordance with van Dijk, B., Value, 2019, n. p.

1.2 Scope of work

The treatment of the topic will be purely theoretical. For this purpose, different effects of financing via private equity investors will be critically examined. Therefore, this assignment will start its main topic with an introduction about private equity investments and SME’s. This is followed by the critical analysis about the investment by general and limited partners and how it is possible to expand the return. After this the most common buyout form is presented as well as the risks characteristics, rules & regulations and the contractual infrastructure. The assignment will end with a conclusion and critical consideration of all the above points and provide an outlook.

2 Fundamentals and theoretical basis

2.1 Definition of private equity

Private equity (PE) corporate finance is used to support a company's growth, to acquire the company financially or to improve its financial structure. In this form of financing, investors purchase shares from the company, mostly in the form of illiquid equities. These shares are not offered and sold publicly, but privately. It is up to the investors to decide how much of the company they want to buy. This can range from a small minority to a major part of the entire company. The aim of the investors is to keep the company stock for an average of three to seven years in order to achieve enormous profits in the form of dividends. After this time, investors often sell off the company shares again.2 Although the risk and return profile is sometimes not entirely transparent, private business financing is recommended from the point of view of private financial investors as it very often promises a higher return than traditional forms of financing.3 Often insufficient financial resources are the reason why a company cannot drive its innovations forward and the development of the company therefore stagnates. Consequently, private equity can be a useful and important building block in corporate finance, as the investment can be used for developing new technologies or products, machinery can be invested to improve production efficiency or the like.4 To show how successful a private equity investment can be, one has to have a look at Apple or Google, to name only a few, which also got their success through a PE investment strategy.5

2.2 Definition of SME

In general, micro, small and medium-sized enterprises (SMEs) turn to be seen as the engine of the economy due to the fact that they create jobs and ensure social stability. SMEs can be found in a wide range of sizes and other parameters, which are briefly explained below. Since many SMEs have links to other enterprises, for example in the form of subsidiaries or daughter / sister companies, it is difficult to distinguish them from large enterprises and groups.6 The traditional classification is given in the form of a table shown below in figure 2.

Figure 2: Definition of SMEs

Abbildung in dieser Leseprobe nicht enthalten

Source: Own figure in accordance with European Commission, SME Definition, 2015, p. 11

A distinction is made between the annual work unit (AWU, which is defined as the number of people employed in the company), the annual turnover and the annual balance sheet total. The table should only serve as a general classification, as even very small companies can generate a very large turnover.7

Figure 3 shows that the topic of financing SMEs by private financial investors can also be of particular importance, for example for the economic development of a country. The number of SMEs in Germany in 2017 was 2,452,629, while the total number of enterprises in Germany was only 3,266,806. This means that the percentage of small and medium-sized enterprises in Germany is just over 75% of the total number of enterprises.8 Additionally to the statistic from the European commission, Peterhoff, Romeo and Calvey states that SME’s are particular for a global economic development, because these kinds of companies are engines for innovative products or services and therefore they create a lot of jobs. Based on their analysis, successful SME establishments can increase the GDP each year 0.1 – 0.2 %.9 The correlations between PE and a GDP increase is also stated by Precup, based to his deep literature review.10

As already briefly explained in the previous section, the aim of private equity financing is to further develop the company the investors are investing in. Since the proportion of SMEs in Germany is very high in comparison, the economic development of the country benefits from the development of these enterprises.

Figure 3: Number of SMEs vs. amount of enterprises in Germany

Abbildung in dieser Leseprobe nicht enthalten

Source: Own figure in accordance with European Commission, Number of SMEs, 2018, n. p.; Statistisches Bundesamt, Enterprises in Germany, 2019, n. p.

3 Description and analysis of actual problem

As already described in the previous chapter, financing by private investors is particularly important for SMEs. On the other hand, too little attention is paid to this form of financing in practice. The reason for this is, among other things, the existence of strict regulations, such as capital adequacy requirements, in particular since the financial crisis, and the restrictive lending policies of banks. For these reasons, access to credit is made more difficult and, if so, only granted under poor conditions.11

Particularly because of the small economic downturn, general partners, who have financed huge sums of money in companies, were uncomfortable in 2018. Often it could be seen that they paid prices they would never have paid before in their planning and thereby achieved a closing value that would have been utopian. Therefore, in the future, risks need to be better assessed and tools need to be put in place to better protect both investors and companies.12

Furthermore, interest in investments in this area may stagnate or even decline due to the large number of risks that investors have to accept. The most significant risks will soon be presented in the next section and critically examined later.

4 Critical analysis

4.1 Introduction to the investment of PE

Since this paper deals with the critical analysis of a private equity financing, the procedure how to set up a financing is not further listed in detail. Instead this chapter will start with introducing the difference between general partners and limited partners. In both cases, limited as well as general partners act as the investor and provide the necessary money for the requiring company. A limited partner has no rights to supervise investments but a general partner is managing these investments actively.13 General partners are usually found, when it comes to invest into new companies and limited partners are usually acting for already established companies with the urge for further development.14

Once that foundation has been laid, the PE investors determine and implement the optimal investment program and structure to fulfill the needs of the requiring company the best possible way.15 PE investors are companies specializing in these transactions16 ; therefore, investors have access to a whole range of tools, for example asset sales, recapitalizations and cash injections if necessary. Finally, after a certain and usually predetermined period of time, the investor divests and leaves the company.17

Therefore, investments based on private equity cannot be seen as a static form of investments, due to several modifications18 which might have to be done during the period of investment.

For PE investors, BERG recommends two ways to get a higher return until the exit:19

- The first option is to increase the value of the equity stake of the investment. This strategy is called a buy-to-sell strategy and is used to increase a profit variable, such as Free Cash Flow (FCF). At a constant multiple at present, the enterprise value (EV) is also increased by increasing the FCF.
- The second option is to increase the net present value of the cash flows until maturity. This can be accomplished by anticipating cash flows. Subsequent cash flows suffer from higher discount rates. For example, cash flows may be preferred by liquidating assets or incurring additional liabilities to pay an additional dividend, also known as recapitalization.

In practical individual cases, it must be examined whether it makes sense to look at one strategy in isolation or to combine both strategies in a suitable way. Due to a different topic of this assignment the explanation remained relatively short, will not be further explained in the following, but will be evaluated in the conclusion.

4.2 Leveraged buyout

As already mentioned in the introduction chapter private equity companies, acting as the investor, try to buy out high-performing companies within different branches using high depts. The aim is to resell this purchased company within five years with a lot of returns for the investor. They do this by applying the right combinations of operational improvements through active process management and the use of specific financial techniques. This model is named “leveraged buyout”. The leverage through which the profits are made plays the core of this strategy. PE partners often finance the buyout with 30% equity and 70% debt. The property acquired by the company is then used as collateral. Furthermore, it is determined how the repayment is to be regulated. Although PE partner finances only 1% - 2% of the purchase price of the acquired company, which is only 0.6% calculated on 30% equity (0.02 x 0.3 = 0.006), up to 20% of the profits are required when the company is sold. If the company is ultimately unable to repay its debts, the company, the employees and the creditors are liable and must pay the costs. This is why PE financing is so interesting for investors. After the buyout PE investors often participate in the companies and act as consultants for financial engineering.20

The leverage structure is also interesting because it creates value in two ways: on the one hand, the interest payments can be claimed for tax purposes, which ultimately increases the cash flows and results in a higher enterprise value, and on the other hand, the value of the investment increases through the repayment of debts.21

The buyout can be realized in different ways and is mainly differentiated by the role the management has to play. The management buy-out (MBO) describes a PE financing in which the already established management takes over the majority of the equity and the main operational management. In a management buy-in (MBI), the established management team no longer acts under sole responsibility but must involve the investor in all decisions. Due to a lack of knowledge about internal operational procedures and processes, MBIs often carry higher risks and therefore fail more often than MBOs.22

In addition to this risk, levered buyouts have additional risks. A high return on equity can only be achieved if the return on total capital is higher than the interest rate for debt capital. A requirement for this is that the company generates a high cash flow with which the debts can be repaid. A further high risk is that if the company fails, a total loss of the invested capital can be expected. The greatest risk, however, is the extremely high level of indebtedness that can be noted in the financed companies. The company is very unstable with regard to this level of indebtedness and can fail even with the smallest fluctuations in the overall economic structure.23

For investors, the insolvency of the financed company is the greatest risk that can happen to them on their way to the planned exit or levered buyout. For example, a reason for impending insolvency can be too much debt on the part of the company. Especially for this reason, insolvency plays such a big risk, because the companies financed by private equity have a very high degree of indebtedness. Reasons for insolvency can be very diverse, but are not further explained in this context as they do not belong to the subject of this assignment; however, it can be said in principle that insolvency is usually the result of management's wrong decisions regarding an incorrect sales policy or other exogenous factors. Possibilities in the event of impending or already occurring insolvency are, on the one hand, to release the capital already invested or to continue to invest with the aim of financial restructuring. Of course, this involves the risk of failing in the market despite the financial restructuring and thereby increasing the value of the lost capital.24

4.3 Risk Characteristics of Private Equity

Within this section the risk profiles of private investments are investigated and highlighted. These risks are only enumerated and described in the following, the critical analysis and conclusion about it will take place in chapter 5.

Due to various differences between corporate financing via publicly traded shares or private equity financing, companies must structure their risk management differently. In the following chapter, the risks associated with private equity financing will be discussed in more detail.25

The major risks which belong to private equity are bankruptcy risks, liquidity risks, reinvestment risks, financing risks, market risks, partnership / manager risks, capital risks, historical data risks and tax management risk.26 But mainly four are the most important, which are presented in the following figure 4. These are the financial risk, the liquidity risk, the market risk and the capital risk.27

Figure 4: Four mainly risks in PE investments

Abbildung in dieser Leseprobe nicht enthalten

Source: Own figure in accordance with Cornelius, P., et. al., Guidelines, 2013, p. 12-14.

Financing risk:

There is a high risk of default in some cases if some private equity investments or interested parties drop out due to late payment. This is due to the fact that the unpredictable timing of the cash flows carries a risk for the investors, despite the contractual obligation.28

Put simply, the investor cannot meet the contractual conditions. In the worst case, the investor can lose all his invested capital due to this risk. The financial crisis in 2008, which demonstrated the explosive nature of financing risks, can also be cited here as an example.29 The question, however, is: How exactly can these risks arise? This is mainly due to over-commitment and market distortion.

To avoid over-commitment, investors must be aware of how long the investment period should be and at what intervals the individual cash flows should be carried out, since not the total amount of the investment is provided at once, but cash flows at regular intervals with the same or different values. This must be done before providing financial support to the company. On the other hand, sudden market distortions (which can have various causes) can occur, in which investors often have to raise more capital and invest it in order to fulfill their contractual obligations, which involves a high risk, as it is unknown how these market distortions will continue to develop.30

Possibilities to measure financing risk can be done by means of a "funding test". In the funding test, the unused commitments are set in relation to the available resources from the commitments.31 Investors can reduce this risk by evaluating their planned future cash flows (which are contractually binding).32

Liquidity risk:

The illiquidity of private equity partners exposes investors to the liquidity risk of assets sold on the secondary market at a discount to the reported net asset value.33

The most significant risk here is that the investor will not be able to simply redeem the capital he has already invested and the contractually agreed capital and use it for other investments. In a way, it is no longer available to the investor. Private equity financing is therefore structured in such a way that the investor cannot simply withdraw in advance, but must fulfill the contractually agreed period. For this reason, there has already been a second market for limited partners with simpler contractual structures. Investing should be less risky, but the market is currently still too small. Due to too many factors that can influence the success of the company and the conditions in the market in which the investor invests, the liquidity risk cannot be measured and evaluated.34

Market risk:

The sometimes strong fluctuations in the market in which the company operates have an impact on the value of the equities or investments held in the portfolio. Due to strong fluctuations, the risks can increase enormously.35

This risk is classified by investments in which an investment has been made and whose value may change due to the current market situation. This risk therefore mainly relates to the capital already invested in the company, i.e. in the form of participations. Diller and Jäckel define market risk as follows: "In private equity, market risk is often defined as the quarterly change (return) of the net asset value adjusted by the cash flows between the two observations."36 Changes that may occur within a quarter are usually changes in the company's performance or financial structure (changes in revenues or EBITDA).37

Market risks can easily be measured because quarterly reports and statistics are available. For this reason, changes can be analyzed quickly and appropriate steps can be taken. Market risks can be reduced if care is taken to invest in different markets, i.e. generally speaking to diversify the investments or portfolio.38

Capital risks:

The value of the realization of a private equity financing can be influenced by various factors. These include, for example, the fund manager who can exert a large influence, the general equity market risk and the volatility of interest rates and exchange rates.39

Capital risk describes the risk that the investor loses all of his invested capital over the period of the investment. Due to the fact that the value of the investor's portfolio decreases, it is not possible to invest in companies that are more successful.40

[...]


1 Cp. Backhaus, D., Evonik I, 2013, n. p.; Handelsblatt, Evonik II, 2013, n. p.; Mohr, D., Evonik III, 2013, n. p.; Schütze, A., Hübner, A., Burger, L., Evonik IV, 2013, n. p.

2 Cp. Divakaran, S., McGinnis, P. J., Shariff, M., Definition private equity, 2014, p. 3.

3 Cp. Phalippou, L., Gottschalg, O., Performance, 2009, p. 1747 ff.

4 Cp. Falat-Kilijanska, I., History, 2019, p. 9-10.

5 Cp. Harris, L., Theory, 2010, p. 261.

6 Cp. European Commission, SME Definition, 2015, p. 3.

7 Ibid.

8 Cp. European Commission, Number of SMEs, 2018, n. p.; Statistisches Bundesamt, Enterprises in Germany, 2019, n. p.

9 Cp. Peterhoff, D., Romeo, J., Calvey, P., SME, 2014, p. 1.

10 Cp. Precup, M., Future, 2015, p. 76.

11 Cp. Müllner, J., Research results, 2012, p. 2.

12 Cp. Bain & Company, Global, 2019, p.3.

13 Cp. Cumming, D., Johan, S., Developing PE, 2007, p. 3222; Harris, L., Theory, 2010, p. 259.

14 Cp. Berg, A., Buyout, 2005, p. 9.

15 Cp. Berg, A., Buyout, 2005, p. 99-129.

16 Cp. Bachmann, L., Schwetzler, B., Company, 2018, p. 905.

17 Cp. Berg, A., Buyout, 2005, p. 99-129.

18 The management has the option to react if the outcome might not be as it was planned before.

19 Cp. Berg, A., Buyout, 2005, p. 123.

20 Cp. Appelbaum, E., Batt, R., Risks during buyout, 2007, p. 1-2.; Jakoby, S., Success factors, 2000, p. 11.

21 Cp. Rauch, C., Umber, M., LBO, 2015, p. 66ff.

22 Cp. Robbie, K., Wright, M., Buy-In, 1995, p. 527 ff.; Wright, M., et. al., Management buy-out, 2000, p. 591 ff.

23 Cp. Romeike, F., Transaction risks, 2007, n. p.

24 Cp. Knauer, T., Wiedemann, D., Risks in LBO, 2013, p. 493-511.

25 Cp. Diller, C., Jäckel, C., Risks, 2015, p. 3.

26 Cp. Vanguard Investment Counseling & Research, Alternative investments, 2006, p. 11-12; Cornelius, P., et. al., Guidelines, 2013, p. 12-14.

27 Cp. Cornelius, P., et. al., Guidelines, 2013, p. 12-14.

28 Cp. Diller, C., Jäckel, C., Risks, 2015, p. 6-7.

29 Cp. Basel Committee on Banking Supervision, Financial crisis, 2008, n. p.

30 Cp. Diller, C., Jäckel, C., Risks, 2015, p. 6-7.

31 Cp. Cornelius, P.,et. al., Risk Management, 2013, p. 114 ff.

32 Cp. Diller, C., Jäckel, C., Risks, 2015, p. 6-7.

33 Cp. Diller, C., Jäckel, C., Risks, 2015, p. 7-9.

34 Cp. Diller, C., Jäckel, C., Risks, 2015, p. 7-9.

35 Cp. Diller, C., Jäckel, C., Risks, 2015, p. 9-10.

36 Diller, C., Jäckel, C., Risks, 2015, p. 9.

37 Cp. Diller, C., Jäckel, C., Risks, 2015, p. 9-10.

38 Ibid.

39 Cp. Diller, C., Jäckel, C., Risks, 2015, p. 10-11.

40 Cp. Getmansky, M., Lo, A. W., Makarov, I., Model, 2004, p. 529 ff.; Emery, K. M., Risk and reward, 2003, p. 43 ff.

Excerpt out of 31 pages

Details

Title
Critical analysis of private equity investments in SME
College
University of applied sciences, Düsseldorf
Course
International Investment & Controlling
Grade
2,0
Author
Year
2019
Pages
31
Catalog Number
V920753
ISBN (eBook)
9783346242389
ISBN (Book)
9783346242396
Language
English
Tags
SME, private equity, investment
Quote paper
Timo Zimenga (Author), 2019, Critical analysis of private equity investments in SME, Munich, GRIN Verlag, https://www.grin.com/document/920753

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