Private Equity

MODULE 1

PRIVATE EQUITY AND VENTURE CAPITAL By Professor Stefano Caselli Università Bocconi and SDA Bocconi

Content 1.  What Is Private Equity and Venture Capital? 2.

Why Companies Need Private Equity And Venture Capital

3.

Private Equity Clusters: Through the Fund's Life Cycle

4.

Seed, Startup, and Early Stage Financing

5.

Expansion Financing

6.

Replacement Financing

7.

Vulture Financing

8.

Private Equity and Venture Capital: Today and Tomorrow – Interview with Fabio Sattin

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Preliminary Definitions The definition of Private Equity (PE) is based on two aspects, each related to the two man characteristics of the PE relation: à  PE is a source of financing: It is an alternative to other sources of liquidity, (such as a loan or an initial public offering (IPO)) for the company receiving the financing. à  PE is an investment made by a financial institution: Private Equity Investor (PEI) in the equity of a non-listed company (i.e. not a public company). Throughout the course, the definition of PE will be used in its broad meaning, which also includes Venture Capital. Venture Capital is a very specific case of PE. It is the investment in the very early stages of a company’s life. 3

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The Need of Financing How does the relationship between the PEI and the venture-backed company (i.e. the company financed by the PEI) work?

The investor gets shares of the equity of the company in return for the inflow of cash. Venture-Backed Company

Debt Assets

es shar

Equity

Private Equity Investor

cash

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The Consequences the Financing As a consequence, the relationship between the venture-backed company and the PEI is based on some relevant issues: •  A company needing money for a certain and clearly identified reason; •  The company collects money with the issuance of equity on the private market, the company does not pay any interest expenses to the PEI; •  The newly issued shares will be bought by the PEI; •  The professional investor will not only become a shareholder but will contribute to the management of the company. The smaller the company is, the larger the contribution of the PEI in the business management will be; •  The professional investor will create profit only through the generation of capital gain, i.e. exiting from the investment by selling shares to someone else on the market. The most critical aspect in PE is the strict relationship between the investor and the entrepreneur. 5

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The Difference between: PE and Investing in a Public Company

PRICING

LIQUIDITY

MONITORING

Public

The price is driven by the market, either upwards or downwards.

Liquidity is very high. Whenever an investor wants to sell the shares of the public company there is always a buyer.

When trading on the stock exchange, there is always a very high level of protection for the shareholders, regardless their stake in the company.

Private

The price is the result of the negotiation process which be both easy or hard.

Selling the shares is not so easy. Since there is no stock exchange, finding a new shareholder can very hard and time consuming.

The shareholders (the PEI) have to protect themselves and the values generated by the company. All of the rules will be stated in a formal agreement.

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Content 1.

What Is Private Equity and Venture Capital?

2.  Why Companies Need Private Equity And Venture Capital 3.

Private Equity Clusters: Through the Fund's Life Cycle

4.

Seed, Startup, and Early Stage Financing

5.

Expansion Financing

6.

Replacement Financing

7.

Vulture Financing

8.

Private Equity and Venture Capital: Today and Tomorrow – Interview with Fabio Sattin

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Why Would a Company Need PE? PE is based on two aspects: §  PE is a source of financing; §  And PE is an investment. … but why would a company need PE? Why should a company let an external investor sit on its board of directors and make managerial decisions? (Note: The bank would have been an outsider.)

The venture-backed company wants to enjoy some direct and indirect benefits that a company can exploit when financed by a PEI.

1. Certification Benefit 2. Network Benefit 3. Knowledge Benefit 4. Financial Benefit 8

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1. The Certification Benefit Due to the long screening phase before deciding to invest in a company, if the PEI finally does choose to invest in the venture-backed company, in a way, that confirms the very high quality of the company’s accounts. This can give a sign of great health of the company and this high quality can be used as a kind of promotion for the venture-backed company’s brand.

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2. The Network Benefit The PEI can give the company a very strong network, in terms of suppliers, customers and banks therefore multiplying its possible contacts.

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3. The Knowledge Benefit The PEI can transfer knowledge to the company: §  Soft Knowledge: the capability to manage the business §  Hard Knowledge: the specific-field knowledge of a business, this applies particularly to high-tech or pharmaceutical industries With this knowledge, an investor can even carry the company through very hard and difficult steps, such as a merger and acquisition (M&A) process. The PEI plays the role of an advisor and mentor.

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4. The Financial Benefit The financial benefit is generated through the injection of cash in return for shares of the venture-backed company. The increase generates the following effect on the cost of capital:

EQUITY

RATING

Positive effect on the cost of capital

If a company needs at least one of the four benefits, then PE is the only choice; if not, there are other sources of financing, each suitable for the life stage where the company has that specific need. 12

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Financing and Life Cycle of a Company Founder & Family

Other Partners

Angels

Private Equity

Banking System

Trade Credit

Financial Markets

These sources are not right for the company does not yet exist at this stage

Development

The risk is too high for banks (capital requirements)

Startup Early Growth Mature Age

To do something complex

Expansion Crisis or decline

It goes back to them

Maybe for an IPO They disappear

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Content 1.

What Is Private Equity and Venture Capital?

2.

Why Companies Need Private Equity And Venture Capital

3

3.  Private Equity Clusters: Through the Fund's Life Cycle 4.

Seed, Startup, and Early Stage Financing

5.

Expansion Financing

6.

Replacement Financing

7.

Vulture Financing

8.

Private Equity and Venture Capital: Today and Tomorrow – Interview with Fabio Sattin

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The Taxonomy of PE Clusters The life cycle of the company is important in two ways: 1. To understand if a company can use PE to accomplish its needs; 2. And to identify the different kinds of PE investment (and the right one). As said in the first clip, the definition of PE is an umbrella definition: It identifies as many clusters as the numbers of the company’s life cycle stages as long as it (the company) is not listed.

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The Taxonomy of PE Clusters Venture Capital Mature Age Expansion Early Growth

Startup Development

Startup Financing

Seed Financing Time = 0: Birth of the company

Replacement Financing

Expansion Financing

Early Growth Financing Crisis or decline Vulture Financing Time

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The Taxonomy of PE Clusters The six life stages each related to the suitable private equity investment are as follows: 1. DEVELOPMENT The life cycle starts with development. It is the moment in which the founders start to create and try to develop the business idea. The corresponding investment of the PEI is seed financing. 2. STARTUP This is when the business actually starts. For this phase, the PE investment is called startup financing. 3. EARLY GROWTH This represents the moment when the company start its growth. In the professional world, this is known as “the financing of the day after.” The PE investment is the early growth financing. These kinds of investment make up the venture capital subsample. 17

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The Taxonomy of PE Clusters 4. EXPANSION In this phase, the sales keep on growing at a very high rate. The corresponding investment of the PE is called expansion financing. 5. MATURE AGE This is the moment when sales growth is stable. The PE investment is called replacement. 6. CRISIS In the end, when (and if) the company comes across its decline, in this case the PE investment will be very hard and it is called vulture financing. In each stage there is a different market and a different risk-return profile.

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The Taxonomy of PE Clusters The PEI can either be a minority or a majority shareholder and depending on which it is, approach can be different: à Hands-On: The investor provides the support a company requires under the forms of the four benefits seen in the second clip and in addition they operate together with the entrepreneur. à Hands-Off: The investor provides the support the company requires in the forms of the four benefits seen in the second clip but the PEI does not give any additional support.

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Content 1.

What Is Private Equity and Venture Capital?

2.

Why Companies Need Private Equity And Venture Capital

3.

Private Equity Clusters: Through the Fund's Life Cycle

4.  Seed, Startup, and Early Stage Financing 5.

Expansion Financing

6.

Replacement Financing

7.

Vulture Financing

8.

Private Equity and Venture Capital: Today and Tomorrow – Interview with Fabio Sattin

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The Venture Capital Fundamental

Venture Capital Mature Age Expansion Early Growth

Startup Development

Startup Financing

Seed Financing Time = 0: Birth of the company

Replacement Financing

Expansion Financing

Early Growth Financing Crisis or decline Vulture Financing Time

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Seed Financing The Seed Financing is the most complex and riskiest activity among the PE investment. It is the investment of an idea or of an research and development (R&D) project, it is in fact very industry-oriented: it usually deals with the biomedical, IT, and the pharmaceutical industries / sectors. Under seed financing, the uncertainty of the project is high because the investor has to trust the idea of the entrepreneur. This is why the managerial role of the investor is very limited. There are two levels of risk: 1.  The capability for the idea to generate on output 2.  If there is an output: does this output have a marketability?

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Seed Financing Because this phase is very risky, there are three golden rules an investor needs to know: 1.  100/10/1 RULE •  •  • 

The investor has to screen one hundred projects, finance ten of them and be lucky (and able) enough to find the one successful one. The activity is risky that you must invest on much more that one project. The investor needs to invest a huge amount of money. The “psychological threshold” is one billion €. By the time the investors find the winning project they will have lost much of their beginning investment.

2.  SUDDEN DEATH RISK •  • 

Because this investment occurs before the company is founded, the investors have to protect themselves in case the person owning the project’s idea suddenly can no longer preform his or her job. The solution to this risk is in the Incubator Strategy, an ad hoc infrastructure in which the inventor can work without worrying about his or her ideas being stolen.

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Seed Financing 3.  SIZE OF THE MARKET • • •

The investors usually invest in the markets they know the best. Despite this, in some cases, the idea may be a good one without a market willing to buy it. Such is the case in which the investors look for venture philanthropy, set up by nonprofit institutions with the investors themselves.

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Startup Financing The Startup Financing is the financing of a new company starting its own initial operations. The entrepreneurs and the founders’ need of cash derives from the necessity to buy the necessary equipment to start (e.g. equipment, inventory, building, etc.) the business. In this kind of financing the risk is still very high, leading to a high level of protection for the investor. The level of risk depends on the fact that the PEI is betting on a business plan. Because the investor is neither a non-profit organization nor a High Net Worth Individual (HNWI), there are several ways in which this can occur. 1.  PUT OPTION •

This tool is used to sell back to the entrepreneur the shares the investor bought. This tool is quite dangerous: it assumes that if the business plan does not work, the founder will still have money to pay off the PE. For this reason, the put option may be used together with a second tool… 25

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Startup Financing 2.  COLLATERAL • 

This is a pledge for the investor over some valuable assets of the newly founded company and this is usually used together with the put option.

3.  STOCK OPTIONS FOR THE INVENTOR • 

Another way to reduce the risk the business plan is not accurate and reliable is to grant the inventor some stock options. In this way the entrepreneur will also enjoy the profitability of the company.

4.  BALANCE BETWEEN MONEY AND SHARES • 

• 

The PEI needs to find the right combination between not losing all its investment (such is the case when the PE owns 95% of the equity) and not having any say in the management of the business (such is the case when the PEI owns 2% of the equity) For instance, for the investor the right balance would be owning 48% of the company. In such case the PEI would have the right to lead the company but the founder is the owner of the company.

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Early Growth Financing Early growth Financing is the financing of the first phase of growth of a new company that has started generating sales. The entrepreneurs and the founders’ need of cash derives from the necessity to buy inventory and to sustain the gap existing between cash flow and money needed. In this phase, the cash flow is still negative, but not as much as in the previous stages of life of the company. The risk is still high for the PEI since it is investing in a very young company and when they make the injection, they do not exactly know how the company will turn out. In this phase, there is a very hands-on approach. If the PEI thinks that the company is based on a good idea, but the business plan is not adequate, it helps rewrite the business plan (à knowledge effect, see Clip 2). For this reason the PEI usually has a high amount of shares in the equity of the company. On average this financing occurs up to the end of the first three year after the startup stage. In this kind of investment, the PEI may also not have any protections, due to the high stake in the equity of the company and to the adoption of a hands on approach. 27

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Conclusion on Venture Capital After an overview on the venture capital different clusters, we can define some common features for this subsample: 1.  The investment is often characterized by a high level of risk. 2.  The PEI needs to have a hands on approach. 3.  The PEI must have a very deep knowledge of the field where the company operates in.

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Content 1.

What Is Private Equity and Venture Capital?

2.

Why Companies Need Private Equity And Venture Capital?

3.

Private Equity Clusters: Through the Fund's Life Cycle

4.

Seed, Startup, and Early Stage Financing

5.  Expansion Financing 6.

Replacement Financing

7.

Vulture Financing

8.

Private Equity and Venture Capital: Today and Tomorrow – Interview with Fabio Sattin

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The PE Clusters In clip 4 the venture capital has been presented. In the following Clips (5, 6, and 7), we will see the other clusters belonging to the PE family which are made for the phases of expansion, mature age, and crisis.

Venture Capital Mature Age Expansion Early Growth

Startup Development

Startup Financing

Seed Financing Time = 0: Birth of the company

Replacement Financing

Expansion Financing

Early Growth Financing Crisis or decline Vulture Financing Time

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Expansion Financing The expansion financing takes place in the fastest phase of growth of a firm to consolidate its position in the market. The investment is only used to sustain the (reducing) gap existing between the cash flow and money needed. In this phase, the level of risk is moderate (and it mostly depends on the business) because the trend of development of the business is well known. In this cluster the stake held by the PE is not usually very high. The expansion financing deals are about the growth of a company.

In an adult company, growth can be:

1.  Internal (or organic) 2.  External According to the growth a company finds itself in, the role of the PEI changes. 31

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Expansion Financing Internal Growth We say that a company grows via internal growth when it plans to grow “by itself.” This means that investments in fixed assets and in working capital will be made. The role of the PEI: the investor needs to provide money to the venture backed company in order to buy and/or sustain the procurement of working capital and to purchase new assets. Because this kind of deal is not difficult for a PEI, the offer is very wide and there is a very high number of investors providing this financing. This kind of financing can be an alternative to a loan. Why should a company choose PE over a bank? Because the need for extra money comes with other needs which can be accomplished with one of the four benefits seen in Clip 2. There may be the need for the PE network or the need to build a good reputation. 32

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Expansion Financing External Growth We say that a company grows via external growth when it plans to grow by acquiring another company (i.e. carry on an M&A) in order to enhance the level of sales and exploit the synergies coming from this operation. This path is much more complicated than the internal growth and it may be undertaken by an adult company in order to enter a new market. The role of the PEI: the investor has to sustain the M&A and in this case, they not only have to provide the venture-backed company with the money necessary, but they also have to: a. b. c. d.

Screen and scout the market Support the negotiation with the potential target Provide the Venture-backed Company with money Support the M&A process

e. f.

(also from a legal and a fiscal point of view) Legal and taxation support The integration process after the operation

Hands on approach

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Expansion Financing External Growth The injection of money can be done in two ways: 1. The PEI invests in the venture-backed company, from which it gets shares and the company has to get enough money to carry on the M&A. If the process is successful the venture-backed company and the target will merge. Venture-Backed Company

Debt

TARGET COMPANY

Assets Equity Equity

PEI

34

5

Expansion Financing External Growth The PROs The venture-backed company will merge with the target and the company will benefit from the synergies. The CONs The venture-backed company is going to give the investor a portion of the synergies created. In order to address this drawback, there is another way to do and M&A using PE.

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Expansion Financing External Growth 2. The second way in which this M&A can be done is as follows: • The PEI builds a Special Purpose Vehicle (SPV). The SPV is an “empty box” built only for the purpose of a specific extraordinary operation. This company does not have any assets nor liabilities and equity before the operation takes place. • The PEI and the venture-backed company collect money from the banking system and put the cash collected in the SPV. In this way, they will have enough capital to buy another company. This option can be used in two cases: a. When the venture-backed company has got a huge financial need and it does not want to further increase the amount of debt. b. The company wants to keep the SPV as a separate entity, this happens when the company does not want the PEI to share the gain deriving from the M&A process. 36

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Expansion Financing External Growth Venture-Backed Company

SPV cash

cash

Debt Equity

Assets

PEI

Equity

cash

cash

BANKING SYSTEM 37

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Expansion Financing External Growth In this way, the PE will not benefit from the synergies created. On the other hand: • This second option is more expensive than the first one; • The PEI has a minor incentive in creating synergies (this may entail that lower synergies will be created) • The company has to obtain financing from banks to invest in the SPV:

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Content 1.

What Is Private Equity and Venture Capital?

2.

Why Companies Need Private Equity And Venture Capital?

3.

Private Equity Clusters: Through the Fund's Life Cycle

4.

Seed, Startup, and Early Stage Financing

5.

Expansion Financing

6.  Replacement Financing 7.

Vulture Financing

8.

Private Equity and Venture Capital: Today and Tomorrow – Interview with Fabio Sattin

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PE Clusters Replacement Financing occurs when a company is beyond the phase of fast growth and is in the mature age stage.

Venture Capital Mature Age Expansion Early Growth

Startup Development

Startup Financing

Seed Financing Time = 0: Birth of the company

Replacement Financing

Expansion Financing

Early Growth Financing Crisis or decline Vulture Financing Time

40

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Replacement Financing Replacement financing takes place in the mature age of a company and the role of the PEI is that of replacing an existing shareholder. A company needs replacement financing when it wants to face strategic decisions linked either to governance, status, or corporate finance decisions. The level of risk is moderate and linked to the quality of the strategic process that has to be put in place. There are three kinds of operations belonging to this cluster: 1. Leverage Buyout (LBO) 2. Private Investment in Public Equity (PIPE) 3. Corporate Governance (CG) Deals These deals do not derive from the arise of need of money of a company.

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Leverage Buyout LBO is very commonly used, especially in the Anglo-Saxon world, where they account for 45%. The role of an investor is not only to finance the company but to identify the target company that the venture-backed company has to buy at 100%. This operation takes place in the following steps: 1. When the PEI identifies the potential target, the PEI itself creates an SPV (for the SPV definition, see clip 5) of which it becomes the full owner (i.e. 100% shareholder). 2. The PEI collects money up and highly leverages the SPV up to a ratio of 90% debt and 10% equity. 3. The SPV receives a huge amount of cash through which it is able to purchase the target company. 42

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Leverage Buyout 4.  The SPV buys the target company either through a negotiation process or through a hostile process and trough an IPO on the stock exchange. The aggressiveness of the operation depends on the level of debt used by the PE to buy the target company. 5.  The PE fully owns the target company. After the acquisition, the PE will sell the target to anther company.

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Leverage Buyout The target company usually has: •  Relevant Cash Flow •  Low D/E ratio •  Assets that can be easily be sold on the market SPV

BANKS TARGET COMPANY

Debt Cash

Debt Assets

Equity

100%

Equity

PEI 44

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Private Investment in Public Equity PIPE is a investment made in a company listed in a stock exchange. Even though the investment is made in a public entity it still belongs to the PE world: the profit mechanism is still not related to the stock exchange. This deal is not done with trading purposes. The purpose is to buy a minority stake and then to sell it to another potential shareholder at a price not based on the stock exchange (which usually is three - four times bigger). This stake has to be big enough to become the biggest shareholder. To make this deal work the PEI has to understand the small amount of shares which is necessary to be the owner of the company. For this reason, these deals can become very aggressive.

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Corporate Governance Deals CG deals, just like PIPE, do not derive from financial needs of the company. The PEI invests in a company to manage the redesign of the corporate governance. These operations occur particularly when there are problems in the management succession. In the case of corporate governance deals there is a reputational risk, rather than a financial one.

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Content 1.

What Is Private Equity and Venture Capital?

2.

Why Companies Need Private Equity And Venture Capital

3.

Private Equity Clusters: Through the Fund's Life Cycle

4.

Seed, Startup, and Early Stage Financing

5.

Expansion Financing

6.

Replacement Financing

7.  Vulture Financing 8.

Private Equity and Venture Capital: Today and Tomorrow – Interview with Fabio Sattin

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PE Clusters This is the final clip related to PE clusters. The final stage of the life cycle of the company will be presented: Vulture (or distressed) financing. Venture Capital Mature Age Expansion Early Growth

Startup Development

Startup Financing

Seed Financing Time = 0: Birth of the company

Replacement Financing

Expansion Financing

Early Growth Financing Crisis or decline Vulture Financing Time

48

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Vulture Financing Vulture financing takes place in the final stage of a company’s life cycle, when it enters its decline phase or, worse, a crisis. Money is used to sustain the financial gap generated from the decline of growth. The financial aid coming from the PEI is used to launch a survival plan. Due to the life stage, this activity is very risky, even though the level of risk also depends on the sector of the venture-backed company. For this reason, the PEI fully understand the field in which the company operates.

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Vulture Financing There are two deals included in this definition: 1. Restructuring financing (or turnaround) 2. Distressed financing The separation of the vulture financing in two different kinds of deals derive from two different ways to differently regulate the deals.

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Restructuring financing

Distressed financing

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Restructuring Financing In restructuring financing, the company is facing a crisis, but is still alive. The need of financing derives from the settlements of debts with banks and with suppliers. At the same time, money can be used to re-launch the business, therefore in some cases money can be used to buy further assets or invested to redesign the business plan. The company needs the strategic support from the PEI

These strategic needs make the PEI not only a financer for the troubled company but also an advisor.

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Restructuring financing

Distressed financing

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Restructuring Financing Because the risk is very high due to the strategic nature of the role of PE, the investor is a majority shareholder: there is a very strong hands-on approach and this needs a majority stake in the equity of the company. For the high difficulty of the deal and due to the elevated riskiness of these projects, it is very difficult to find a PEI investing in such deal, it is more of an investment banking activity.

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Restructuring financing

Distressed financing

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Distressed Financing Contrarily to replacement financing, distressed financing is a very common deal for PEI and it occurs when the company is dead. This may look a bit contradictory to the other clusters of PE in which the main goal of a PE deal is to finance a company finding itself in the need of money. The aim of PE is not in fact to merely finance the company, rather to buy the relevant (and valuable) assets of the company. In this case, an investor is going to buy: •  •  •  •  • 

Patents Brands Contracts Equipment … 53

Restructuring financing

Distressed financing

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Distressed Financing Why would a PEI want to buy the assets of a defaulted company? 1. In some cases, the PE may be a trader of assets. This means that the investment is made only to sell such assets to a third buyer. 2. In other cases, the PEI buys the assets because it inserts them in other venture-backed companies in its portfolio. The assets are bought before a court, and the negotiation process can be tough between the court and the investor. As a matter of fact, it is a desire of the court to maximize the liquidity of a company when it goes bankrupt, so that it can pay off its debts. Sometimes the court implements the “poison pill.” This means that the PEI is going to buy a valuable asset mandatorily together with another less valuable assets or together with a debt of the company. These deals work differently according to the different countries. In the US, these deals work very well: there is a chapter in the United States Bankruptcy Code dedicated to the distressed financing (Chapter 11) (find out more about Chapter 11 at this link).

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Content 1.

What Is Private Equity and Venture Capital?

2.

Why Companies Need Private Equity And Venture Capital

3.

Private Equity Clusters: Through the Fund's Life Cycle

4.

Seed, Startup, and Early Stage Financing

5.

Expansion Financing

6.

Replacement Financing

7.

Vulture Financing

8.  Private Equity and Venture Capital: Today and Tomorrow – Interview with Fabio Sattin

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Who Is Fabio Sattin? Founder of a Private Equity Firm: Private Equity Partners Chairman of the EVCA in the past. Professor of “Private Equity and Venture Capital” at Bocconi University

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Q&A Today, what is state of the art in private equity and venture capital all around the world? “Today PE is an engine for the economic growth, especially for Europe and Italy. As for Europe, one of the main hurdles is made up of the big role the banking system plays (huge difference with respect to the US). In Europe, There is the need to create a new financial intermediary, not “bankingrelated,” which should possess specific knowledge on companies and their development and this is why PE can be (and is) so important in Europe. Nowadays we can see an increasing interest in private debt, again standing as a signal that PE in Europe plays a fundamental role.”

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Q&A According to you, are Europe and the US are two different worlds concerning private equity? “There is a European way to play PE which is very different from the American one. I recall that years ago the, then Italian Ambassador, a big PE player in the US, once said that Europe is a completely different market. Why is that? Europe (excluding the UK) can be taken as one very big country with many family businesses and PE can help them to develop à this changes the approach a PE has when investing in a family business. We can say that PE has adapted also to invest in each specific country. Basing on my experience in the US, I can tell that in continental Europe, PE players support generational change: again, a different way to do PE.”

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Q&A What are the key trends in the market for private equity and venture capital? “After the financial crisis, today PE is definitely changing like many other industries. In the first place there is a problem at the fundraising level, which has become more difficult and PE firms had to come up with new strategies to do fundraising, like club deals, co-investments, SPACs. The second problem is the fees’ structure. The fact that the fees are calculated on the committed capital is under a review process by many funds. Again, I see many sovereign funds investing in PE. On the deal-side, in Europe SMEs are the main target for PE investments (€ 45 bio invested each year). In the future, I think that the investments may have a different structure.”

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Q&A The industry is changing: new strategies are coming up, in the US we see majority investments, whereas we see minority investments in Europe. How do you see the market in terms of strategic choices of the biggest players in the market, as the company of yours? “One of the most important aspects is the fact that in Europe most deals are not very large. In addition, minority investments will still make the majority of the deals. For these reasons, PE firms are boosting their industrial skills in order to enhance their industrial know how à PE is not a replacement for the managers, they are active owners, not active managers. Having said that, it is necessary for the PE investors to have a solid knowledge of the company and of the sector in order to help companies to develop their strategies. This must be done without overlapping the role of the management team.”

MODULE 2

PRIVATE EQUITY AND VENTURE CAPITAL By Professor Stefano Caselli Università Bocconi and SDA Bocconi

Content

1

1.  Private Equity Investors: The Map to Investigate 2. 

Closed-End Funds in Europe: An Overview

3. 

Closed-End Funds in Europe: Lifetime of a Fund

4. 

Management Fees and Carried Interest

5. 

Investment Firms and Banks in Europe

6. 

Limited Partnerships in the US

7. 

The SBIC Experience in the US

8. 

Funds and VCT in the UK

9. 

Taxation around the World

10.  New Solutions: SPACs, Private Debt Funds, Venture Philanthropy, and Crowd Funding

11.  Calculating Returns (Exercise)

1

Introduction In the previous module we have seen: •  When a company needs the intervention of PE •  The deals a PEI can undertake to provide the financial aid a company needs We need to explore the world of the investors. In this module we will discover: •  Who can be a PEI •  How an investor works •  How the regulation works for PE •  The remuneration of PE

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The Formats Regardless where the deal occurs, there are two formats, each having its regulation and players: 1. The European Union format: This format is regulated by a Directive of the European Union. 2. The Anglo-Saxon format: This format is regulated by US and UK laws. Using one of the two formats does not necessarily mean that the deal occurs in the area of the format.

The European format has been adapted and is now used in, Brazil, and Russia, and others; whereas the Anglo-Saxon format is also used in India and Australia.

4

1

The European Union Format In the European Union, there are two Directives regulating PE activity and, at the same time, they regulate the entire financial system in the European Union: •  The Banking Directive •  The Financial Services Directive Behind these directives lies the idea that the financial system in Europe has to be managed with stability, for this reason, before a financial institution becomes active, there must be an approval by both the local and central authorities.

5

1

The European Union Format Within this framework, there are three players that can be a PEI: 1.  Banks –  – 

In Europe they are universal and they can provide any kind of financial service

Regulated by the banking directive

2.  Closed-End Funds –  – 

They have an ad hoc structure and they are The most suitable player that can be a PE investor

3.  Investment Firms

Regulated by both: -  the financial services directive -  the new AIFM (Alternative Investment Fund Managers) directive

6

1

The Anglo-Saxon Format The main difference between the two formats is the idea that each has of PE. In the Anglo-Saxon world, PE is not a financial service (as it is in Europe), rather it is an entrepreneurial activity. This idea means that when talking about PE in the Anglo-Saxon world, the regulatory framework is made up of: Common law + Ad hoc fiscal rules + Special regulations for the PE world In the end, in the Anglo-Saxon format, there is no supervisor.

7

1

The Formats The taxonomy of the formats must be clear and must be applied as follows:

Local players (i.e. the perimeter of the investment is within the country of origin of the PEI itself: a US PEI investing in the US only is a local player) must apply the legal framework of the country of origin of the investor. Global players (i.e. the perimeter of the investment is outside the country of origin of the PEI itself) can opt for one format or the other one according to the needs of their portfolio.

8

Content 1. 

Private Equity Investors: the Map to Investigate

2.  Closed-End Funds in Europe: An Overview 3. 

Closed-End Funds in Europe: Lifetime of a Fund

4. 

Management Fees and Carried Interest

5. 

Investment Firms and Banks in Europe

6. 

Limited Partnerships in the US

7. 

The SBIC Experience in the US

8. 

Funds and VCT in the UK

9. 

Taxation Around the World

10.  New Solutions: SPACs, Private Debt Funds, Venture Philanthropy, and Crowd Funding

11.  Calculating Returns (Exercise)

2

2

The European Union Format As anticipated (module 2 clip 1), PE in Europe is a financial activity regulated within the financial system legal framework and there are three vehicles that can be a PEI in Europe: 1.  Banks –  – 

In Europe they are universal and they can provide any kind of financial service

Regulated by the banking directive

2.  Closed-End Funds –  – 

They have an ad hoc structure and they are The most suitable player that can be a PE investor

3.  Investment Firms

Regulated by both: -  the financial services directive -  the new AIFM (Alternative Investment Fund Managers) directive

In this clip, the attention is focused on closed-end funds. 10

Banks

Closed-End Funds

Investment Firms

2

Closed-End Funds An investment made through closed-end funds consider a two-level system involving two different institutions: •  Asset Management Company (AMC) •  Closed-End Fund The AMC is a financial institution. It can host many funds at the same time (they can be both closed and open-end) and it can manage financial services as defined by the Financial Services Act (i.e., personal management of savings, dealing, brokerage, advisory). The closed-end fund is a separate entity that invests money for a pool of investors.

AMC When referring to closed-end funds, there are three players to consider:

Closed-End Fund Investors 11

Banks

Closed-End Funds

Investment Firms

2

Closed-End Funds: Players AMC Closed-end Funds Investors

Financial institution approved and supervised by the local authority, whose task it is to manage the fund. The AMC shares some characteristics with a consulting company. In fact, it is not a financial institution but a cluster of people advising. There are AMCs owned by banks, private individuals (boutiques of PE), and the government. There are no constraints in terms of shareholders, except for the commitment the AMC must own in every fund, which must be equal to 2%.

12

Banks

Closed-End Funds

2

Investment Firms

Closed-End Funds: Players AMC

A fund is a separated amount of money, given by the investors, managed by the Asset Management Company. This amount of money can be used to invest into financial assets or in other assets such as real estate, gold, etc.

Closed-end Funds Investors

A fund can be open end or closed end, where the distinction is driven by two parameters: •  The maturity (fixed or not) •  The amount of money to invest (fixed or not). These funds can never use debt Closed end funds have a fixed maturity and a fixed amount of money to invest. 13

Banks

Closed-End Funds

Investment Firms

2

Closed-End Funds: Players AMC Closed-end Funds Investors

Investors put money in the funds and from the moment when they do that, they automatically lose any right to have a tailor-made investment. Their investment will be managed by the AMC together with the other money belonging to the fund. When they invest, they receive a certificate with the value they invested in the fund. Typically investors are: -  High net worth individuals -  Banks -  Insurance companies -  Pension funds -  Corporations -  Governments

14

Banks

Closed-End Funds

Investment Firms

2

Closed-End Funds: Rules for the AMC The existence of this “double level” is necessary to analyze the (very few) rules both for the asset management company and for the closed-end fund - the same all over Europe. The choice of a short albeit well-organized system responds to the need to better regulate a country-specific financial system.

For the AMC, the set of rules concerns:

Minimum requirements to operate Governance rules

The rules are verified by the country supervisor, checking over the whole life of the AMC

Management rules

15

Banks

Closed-End funds

Investment Firms

2

Closed-End Funds: Rules for the Fund For closed-end funds, the set of rules concerns three items: General rules Internal code of activity Investment policy

16

Content 1. 

Private Equity Investors: the Map to Investigate

2. 

Closed-End Funds in Europe: an Overview

3

3.  Closed-End Funds in Europe: Lifetime of a Fund 4. 

Management Fees and Carried Interest

5. 

Investment Firms and Banks in Europe

6. 

Limited Partnerships in the US

7. 

The SBIC Experience in the US

8. 

Funds and VCT in the UK

9. 

Taxation around the World

10.  New Solutions: SPAC, Private Debt Fund, Venture Philanthropy, and Crowd Funding

11.  Calculating Returns (Exercise)

Banks

Closed-End Funds

Investment Firms

3

Closed-End Fund In the previous clip, closed-end funds were presented, together with the relative regulatory frameworks and the players they interact with over their life (i.e. the investors and the AMC). The goal of this clip is to understand how those funds work. All the rules concerning the functioning of a closed-end fund are stated in the set of rules called internal code of activity (see module2, clip2), approved by the authority.

18

Banks

Closed-End Funds

Investment Firms

3

Closed-End Funds in Europe Closed-end funds are the most important vehicle in Europe for PE. Their length is fixed, meaning that the investors can invest in the beginning and divest in the end of the fund. The liquidity is no problem for the investors nor the AMC. For this reason closed-end funds are the perfect tool to undertake a PE investment. Typically, the average size of a fund is €100-300 million and this amount is divided into tickets an investor can buy. Each ticket typically has a value of €1 million. For instance, if the amount of money of the fund is €100 million, and each ticket is worth €1 million, the fund needs (as a maximum) 100 investors. 19

Banks

Closed-End Funds

3

Investment Firms

Closed-End Fund: Lifetime of a Fund When presenting the lifetime of a closed-end fund, some milestones must be set. In its lifetime the following moments are the most important: •  •  •  • 

Time Time Time Time

-1.5

0 3 N – 0.5 N+3

(where N is the end of the fund)

3

0

Fundraising

Draw down period

N – 0.5

Getting to time N

N

N+3

Extra time

20

Banks

Closed-End funds

Investment Firms

3

Closed-End Fund Fundraising -1.5

0

Fundraising

Before launching any activity, the AMC needs the approval by the authority, where the approval depends on three criteria: • 

The size of the fund

• 

The value of every ticket

• 

The investment target.

Once the approval is granted, the AMC has as a maximum 18 months to collect the all of its money. Generally, 4-5 months is the average time taken by an AMC to collect the whole capital that will be invested. As a matter of fact, if the AMC does not collect money before the time allowed, they usually stop beforehand, otherwise they would lose their reputation. In fact, 50% of the funds all over Europe do not manage to get to time 0. 21

Banks

Closed-End Funds

Investment Firms

3

Closed-End Fund Draw Down Period 3

0

Draw Down Period

At time 0, the fundraising phase comes to an end. In this period the AMC has the possibility ask the investors to deposit a percentage of their commitment (e.g. 10%). The time is set at 3 years, because collecting all the capital from the investors will take much more time than it does in capital markets. In the time going from time 0 and the third year, the closed-end fund has to cash in all the money previously subscribed by the investors, who can also deposit their investment with installments.

22

Banks

Closed-End Funds

Investment Firms

3

Closed-End Fund Getting to Time N 3

N – 0.5

N

Getting to Time N

At time 3, the investors have to have entirely injected all the money equivalent to their tickets. So, after the three years, the AMC keeps on investing until the end of the fund. In fact, some investing activity can have already taken place before Time 3 but, not using the entire amount. The length of the fund can be defined by the AMC, as long as it is shorter than 30 years. Usually, 90% of the funds have a maturity of 10 years. As a matter of fact, for an AMC, 10 years is a maturity long enough to make two investments: 1.  Year 0 - 3: first investment 2.  Year 3 - 5: exit from the first investment 3.  Year 5 - 7: second investment 4.  Year 7 - 10: exit from the second investment

23

Banks

Closed-End Funds

Investment Firms

3

Closed-End Fund Extra Time N

N+3

Extra Time

After the end of the closed-end fund there is the possibility to use up to three year of extra time. As was presented in the first week, PE tends to have low liquidity, and as such sometimes an AMC does not have the whole liquidity it would need to pay off the investors right away. When the fund finally comes to an end, the AMC valuates the fund and spreads this value among all the investors coherently with the amount of tickets bought by each investor in the beginning of the fund.

24

Content 1. 

Private Equity Investors: the Map to Investigate

2. 

Closed-End Funds in Europe: an Overview

3. 

Closed-End Funds in Europe: Lifetime of a Fund

4

4.  Management Fees and Carried Interest 5. 

Investment Firms and Banks in Europe

6. 

Limited Partnerships in the US

7. 

The SBIC Experience in the US

8. 

Funds and VCT in the UK

9. 

Taxation Around the World

10.  New Solutions: SPAC, Private Debt Fund, Venture Philanthropy, and Crowd Funding

11.  Calculating Returns (Exercise)

Banks

Closed-End Funds

Investment Firms

4

The Economic Mechanism of an AMC In closed-end funds there is an interaction between the investors and the AMC. Investors will be paid, and a gain or loss will be generated at the end of the fund (i.e. either at time 10 or at time 13 (see module2 clip3)). What about the managers of the funds? The goal of this clip is to understand how the AMC is remunerated over the fund’s lifetime.

26

Banks

Closed-End Funds

Investment Firms

4

The Economic Mechanism of an AMC Over the life of the investment, the AMC receives two different kinds of remunerations: 1.  Management fees 2.  Carried interest

Please note: the rules that will be presented are also valid for fund managers operating in the US as long as they operate in PE deals.

27

Banks

Closed-End Funds

Investment Firms

4

1. Management Fees Management fees correspond to the amount of money an AMC receives every year from closed-end funds. Closed-end funds are the vehicles generating: •  Revenues, in the form of capital gains •  Dividends coming from the companies in which the investment is made •  Losses, in case the deal is not successful The management fees is a fixed percentage of money calculated on the value of the closed-end fund in the beginning of the fund itself. For instance, in the case of a closed-end fund being worth €100 million bearing management fees at 2%, every year the AMC receives €2 million from the fund.

28

Banks

Closed-End Funds

Investment Firms

4

1. Management Fees The management fees must be precisely calculated for they have to cover: •  Operating costs •  Remuneration of the advisor helping the AMC in the consulting activity •  Remuneration of the technical committee The percentage of the management fees is in fact computed with the capital budgeting approach. That means that it is computed replying to the question: “Is the amount enough to properly cover all expenses?” The reply is in fact not in the percentage per se, rather it stands in the absolute value of these fees.

29

Banks

Closed-End Funds

Investment Firms

4

1. Management Fees In case an AMC belongs to a bank, all the above-listed costs will be easily covered. On the contrary, if the AMC is an independent entity, covering all the above-listed expenses can be very tough. For instance, in venture capital, AMCs are owned by professionals and not by financial institutions, because they need a workforce who can fully be devoted to the venturebacked company.

30

Banks

Closed-End Funds

Investment Firms

4

2. Carried Interest The second source of remuneration for the AMC is made up of the carried interest. Maximizing the carried interest is the ultimate goal and desire of an AMC.

It is computed only at the end of the closed-end fund’s life cycle.

CARRIED INTEREST = % x (Final IRR – Hurdle IRR) IRR: it is a discount rate that equals the investments with the present values of the future returns of such investments.

31

Banks

Closed-End Funds

Investment Firms

4

2. Carried Interest CARRIED INTEREST = % x (Final IRR – Hurdle IRR) The carried interest is the spread between the final IRR and a hurdle (a.k.a. threshold) IRR multiplied by a fixed percentage. Usually, the fixed percentage ranges between 25-30%; the hurdle rate ranges between 7-8%. This means that, at the end of the fund, the AMC will receive a carried interest if and only if the final IRR is larger than 7-8%.. The carried interest formula is also called “the waterfall mechanism.” This mechanism can be used either with or without catch-up, where the choice to calculate IRR one way or the other is up to the AMC and must be agreed in the Internal Code of Activity. •  Without catch-up: The carried interest is computed on the difference between the final IRR and the hurdle rate. •  With catch-up: The carried interest is directly computed on the final IRR. 32

Content 1. 

Private Equity Investors: the Map to Investigate

2. 

Closed-End Funds in Europe: An Overview

3. 

Closed-End Funds in Europe: Lifetime of a Fund

4. 

Management Fees and Carried Interest

5

5.  Investment Firms and Banks in Europe 6. 

Limited Partnerships in the US

7. 

The SBIC Experience in the US

8. 

Funds and VCT in the UK

9. 

Understanding Taxation Around the World

10.  New Solutions: SPAC, Private Debt Fund, Venture Philanthropy, and Crowd Funding

11.  Calculating Returns (Exercise)

5

PE Players in Europe As anticipated in clip 1 of this module, PE in Europe is a financial activity regulated within the financial system’s legal framework and there are players players that can be a PE investor in Europe:

1.  Banks 2.  Closed-end funds 3.  Investment firms In this clip, the attention is focused on the other two players of the European format.

34

Banks

Closed-End Funds

Investment Firms

5

PE Players in Europe: Banks In Europe, banks are universal: They can undertake any kind of financial activity except for the following ones: •  •  • 

Collective asset management activity Insurance activity Non financial activities

However banks can hold equities of AMCs, insurance companies, and non financial firms.

35

Banks

Closed-End Funds

Investment Firms

5

PE Players in Europe: Banks When a bank wants to directly invest in the private equity of a company (whether it be listed or non), not only does it have to follow very strict constraints and rules but it is necessary for the bank to set aside a lot of regulatory capital, due to the strict regulation constraints imposed on banks by Basel II and III. This means that the capital gain obtained through the investment can be counterweighted by the regulatory capital it has to set aside.

36

Banks

Closed-End Funds

Investment Firms

5

PE Players in Europe: Banks For the reasons mentioned above, it is very rare that a bank invests directly and become a PEI. Banks usually invest in closed-end funds to ultimately participate to some PE activities. Banks only directly invest if there needs to be an urgent intervention to save a company in a certain industry or area or if the venture-backed company is of particular importance.

37

Banks

Closed-End Funds

Investment Firms

5

PE Players in Europe: Investment Firms Investment firms in Europe are regulated by the Banking Directive and can undertake the same activity as banks with the exception of collecting money through deposits. According to the regulation they comply to, there are two kinds of investment firms.

38

Banks

Closed-End Funds

Investment Firms

5

PE Players in Europe: Investment Firms Type 1 Investment firms They do not have any specific constraints to manage their activities and the supervision impact is quite soft. They do not undergo any regulatory capital rules. Type 2 Investment firms They face the same constraints set for banks and for them the supervision impact is hard. In this case, all investments undertaken by the firm entail a regulatory capital as if they were banks.

In Europe, the most widespread kind of firm is the second type.

39

Banks

Closed-End Funds

5

Investment Firms

PE Players in Europe: Investment Firms The balance sheet of an investment firm.

Private Equity Investments

Debt Cash Equity

A-Shareholders

B-Shareholders Collected through Debt and Equity

40

Banks

Closed-End Funds

Investment Firms

5

PE Players in Europe: Investment Firms The role of the two kinds of shareholders is necessary to replicate, in the investment firm, the relation existing between an AMC and the investors within closed-end funds. As a matter of fact: •  A-shareholders: act as an AMC. They are remunerated with the management fees and with a yearly carried interest (it is computed every year because the investment firm does not come to and end, unlike the closed-end fund). •  B-shareholders: act purely as investors and cannot influence the management of the investment. They are remunerated with the difference between the profits and the carried interest given to A-shareholders.

41

Banks

Closed-End Funds

Investment Firms

5

PE Players in Europe: Investment Firms There may be at least two main reasons to use investment firms to invest PE: •  Investors may want to leverage (closed-end funds cannot use debt). •  A small group of investors may want to create a captive vehicle and they do not want to comply to very strict regulations. Such is the example of the so-called “family offices,” a group of family members who want to invest their own money.

42

Content 1. 

Private Equity Investors: the Map to Investigate

2. 

Closed-End Funds in Europe: An Overview

3. 

Closed-End Funds in Europe: Lifetime of a Fund

4. 

Management Fees and Carried Interest

5. 

Investment Firms and Banks in Europe

6

6.  Limited Partnerships in the US 7. 

The SBIC Experience in the US

8. 

Funds and VCT in the UK

9. 

Understanding Taxation Around the World

10.  New Solutions: SPAC, Private Debt Fund, Venture Philanthropy, and Crowd Funding

11.  Calculating Returns (Exercise)

6

PE Players in the Anglo-Saxon World With this clip, we will start looking at the Anglo-Saxon world. We will see the mechanisms according to which PE works in the US. Looking at the Anglo-Saxon markets, it’s can be noted that investments in PE are not regulated by a regulation framework, rather they are market-related. This derives from the Anglo-Saxon idea that the market discipline is more powerful and important than a financial authority regulation.

44

6

PE Players in the US The US financial market is driven by common law and great importance is covered both by the local courts’ work and by the federal court’s work. Some federal acts have created a general framework for the financial system. This framework is not based on financial institutions but on relevant financial activities. The pillars are represented by: •  Discipline on stock exchange and securities •  Corporate governance rules •  Discipline for insurance and pension funds •  General rules for banks

45

VCF

SBIC

Banks

Corporate Venture

Business Angels

6

PE Players in the US In the US system, there is evidence of: 1.  2.  3.  4.  5. 

Venture Capital Funds (VCFs or simply, funds) Small Business Investment Companies (SBICs) Banks Corporate Venture Business Angels

The two institutional vehicles in the US market

46

VCF

SBIC

Banks

Corporate Venture

Business Angels

6

Venture Capital Funds Venture capital funds are the most popular PE instruments in the US. Regardless of the name, they can operate in every PE deal. The legal entity supporting a VCF is called the limited partnership (LP). An LP is one of the typical structures to create a company in the US, whereas common organizational forms are: sole proprietorship, partnership, limited-liability partnership, limited partnership, S-corporation and C-corporation. That means PE investment is considered a business activity and not a financial activity as it is in Europe.

47

VCF

SBIC

Banks

Corporate Venture

Business Angels

6

Venture Capital Funds An LP is the legal entity with the mandatory presence of two different groups of shareholders: LP

Debt Assets Equity

Limited Partners General Partners

The Limited Partners (LPs) must own 99% of the equity of the LP, whereas the General Partners (GPs) must own 1% of it. This is set by US law.

48

VCF

SBIC

Banks

Corporate Venture

Business Angels

6

Venture Capital Funds Limited Partners are solely investors. They do not manage the company and are limitedly liable to the extent of their investment. General Partners are the managers of the company and they are fully liable for the LP liabilities. This means that in the worst-case scenario they lose everything.

COMPARISON WITH EUROPE LPs are like the investors in closed-end funds. GPs are like the AMCs in closed-end funds. Even though the holding stake is different

49

VCF

SBIC

Banks

Corporate Venture

Business Angels

6

Venture Capital Funds What does being “fully liable” mean? It means that the GPs are responsible for the liabilities. Full liability is something that is not stated in the rules of the closed-end funds (Note: remember that closed-end funds can not leverage). The fact that a fund can leverage makes it a hedge fund, entailing a higher risk-return combination than the one in Europe. The functioning of a fund is regulated by a Limited Partnership Agreement and it is made by GPs and LPs, where the content is very similar to the one of the internal code of activity, except for the parts referring to debt policy. The only difference with the fact that in Europe, it is a code, therefore in case of a legal battle they go before a Supervisor. On the contrary in the US it is a contract, then they go before a Court.

50

VCF

SBIC

Banks

Corporate Venture

Business Angels

6

Venture Capital Funds What does being “fully liable” mean? In addition the GPs want to protect themselves due to the full liability. This is why GPs usually is a management company and it operates via a Limited Liability Partnership (LLP) working just like an AMC in Europe. GPs want to be protected, but the LPs do not want them to be too safe. This is why the assets of the LLP will be a collateral of the debt of the VCF.

51

VCF

SBIC

Banks

Corporate Venture

Business Angels

6

Venture Capital Funds What does being “fully liable” mean? LP

LLP

Debt

Debt

Cash Equity

1%

Assets

General Partners (100%)

Equity 99% Limited Partners

Investment 1 Investment 2 Investment n

52

VCF

SBIC

Banks

Corporate Venture

Business Angels

6

Venture Capital Funds Limited partners are typically banks, insurance, pensions funds, private investors, etc. The great success of limited partnership is due both to the simple scheme of functioning and to the tax transparency. The US government decided to have a tax law with specific reference to PE. This entails that if in any US State there is a PE investment, taxes = 0% provided that: •  The fundraising lasts 1 year •  The maturity is 10 years •  The maximum extra-time is 2 years In all other cases, investors pay taxes. These benefits can be enjoyed if you do not operate in the US, as long as the VCF is in the US.

53

Content 1. 

Private Equity Investors: the Map to Investigate

2. 

Closed-End Funds in Europe: An Overview

3. 

Closed-End Funds in Europe: Lifetime of a Fund

4. 

Management Fees and Carried Interest

5. 

Investment Firms and Banks in Europe

6. 

Limited Partnerships in the US

7

7.  The SBIC Experience in the US 8. 

Funds and VCT in the UK

9. 

Understanding Taxation Around the World

10.  New Solutions: SPAC, Private Debt Fund, Venture Philanthropy, and Crowd Funding

11.  Calculating Returns (Exercise)

VCF

SBIC

Banks

Corporate Venture

Business Angels

7

PE Players in the Anglo-Saxon World With this clip, we continue the overview over the US players within PE with particular attention on SBICs and some final considerations made concerning corporate ventures, business angels and banks.

55

SBIC

VCF

Banks

Corporate Venture

Business Angels

7

SBIC SBICs were created through the Small Business Investment Company Act of 1958. They are considered the beginning of the PE development in the US because they were created to stimulate the VC market. It is a legal entity, in which one of the two shareholders must be a US Public Admin, while the other shareholder can be any kind of shareholder (it is usually a bank, corporation, or individual).

Debt Assets

Shareholder 1 (50%)

Equity Shareholder 2 (50%)

Sharing stands for a joint venture

56

VCF

SBIC

Banks

Corporate Venture

Business Angels

7

SBIC: Duties and Rights The Public Admin that holds 50% of the equity of the company is a pure investor: it cannot manage the company. On the contrary, the non-public admin investor has the duty and the right to manage the investments and the whole company. Both shareholders receive a management fee, but the profit distribution (calculated with the carried interest approach) is asymmetric: the US PA will get the remuneration up to a threshold stated in the SBIC Agreement, whereas the extra profit generated through the investments belongs to the other shareholder. Losses are equally distributed.

57

VCF

SBIC

Banks

Corporate Venture

Business Angels

7

SBIC: Duties and Rights 33% of debt can be borrowed from the Federal Reserve System at a very low and fixed rate which is set yearly. Capital gains and other revenues are free from tax and the taxation starts with the distribution of earnings. This kind of “free-from-tax” vehicle can not be implemented in the European Union because within the European Union there is a rule of “non-State aids” even if both in Europe and in Asia the introduction of a similar mechanism is a highly discussed topic. This mechanism is very popular in the US, because with a partner belonging to the Public Administration, some investors feel they can invest even in riskier deals. SBICs are considered among the best models of PPPs (Public-Private Partnerships).

58

VCF

SBIC

Banks

Corporate Venture

Business Angels

7

Other US Players Banks Also in the US, banks can invest in PE although like in Europe they have many constraints, therefore it is very rare that they directly invest in PE. They usually act as either GPs or LPs in VCFs. Corporate Ventures They are not proper legal entities, rather they are a division or a department of a corporation which wants to invest in venture capital. The only aim of the CV is to run seed and start-up financing. The investment is done to promote R&D, outputs, patents and unlike in VCFs, the aim is not to generate IRR but to enhance the value for the corporation.

59

VCF

SBIC

Banks

Corporate Venture

Business Angels

7

Other US Players Business Angels They are PE investors without any professional skills. Example of such could be foundations, universities, and individuals. They can also be high net worth individuals, charities, and foundations, and in this case can benefit of the QSBS rule (Qualified Small Business Stock). This means that if they invest in PE and, at the end of the investment, the capital gain is immediately invested in another private company under the form of PE, taxes are not paid. This is a huge incentive for PE investments. They are mostly active in venture capital, mostly with seed and start-up financings.

60

Content 1. 

Private Equity Investors: the Map to Investigate

2. 

Closed-End Funds in Europe: An Overview

3. 

Closed-End Funds in Europe: Lifetime of a Fund

4. 

Management Fees and Carried Interest

5. 

Investment Firms and Banks in Europe

6. 

Limited Partnerships in the US

7. 

The SBIC Experience in the US

8

8.  Funds and VCTs in the UK 9. 

Understanding Taxation Around the World

10.  New Solutions: SPAC, Private Debt Fund, Venture Philanthropy, and Crowd Funding

11.  Calculating Returns (Exercise)

8

Players in the Anglo-Saxon World After having seen how the PE market works in the US, we shift focus to the UK whose mechanisms are more similar to the US rather than to the rest of Europe. As with the US, the UK financial market is driven by common law and great importance is played by the courts. However, it is possible to use the schemes designed through EU Banking and Financial Services Act: that means we find out a great variety of solutions/typologies of equity investors.

62

VCF

VCT

Banks

Business Angeles

Local PPP

8

PE Players in the UK In the UK system, there is evidence of: 1.  2.  3.  4.  5. 

Venture capital funds (VCF) Venture capital trusts (VCT) Banks Business Angels Local PPPs

63

VCF

VCT

Banks

Business Angeles

Local PPP

8

Venture Capital Funds UK VCFs are not built under the European scheme of closed-end funds but are legal entity operating like LPs like in the US. As a matter of fact the UK and the US aim to attract the same investors, also in terms of investors’ risk-return profile. As in the US, limited partners generally are private investors, banks, pension and insurance funds, and corporate investors; and they are allowed to leverage. A UK fund must have a set maturity of 10 years.

64

VCF

VCT

Banks

Business Angeles

Local PPP

8

Venture Capital Trust: The General Definition Venture Capital Trusts (VCTs) were introduced in 1997 and have had a great success in the UK market. Started in the UK but nowadays it has become a sort of format, and there is evidence of this tool in India and in Australia. They are based on the concept of the UK Trust. A trust is a very old British institution (there is evidence of the first trusts in the 11th and 12th century) and it is an entity, not a company. The trust was born in the first place for succession issues, as a matter of fact through this mechanism the owner (called the settlor) does not have to manage the assets, for a third player will do it (the trustee) and that is fully liable. In case the VCT has a maturity, at the end of the VCT the owner gets back the assets belonging to the trust.

65

VCF

VCT

Banks

Business Angeles

Local PPP

8

Venture Capital Trust: Application in PE In terms of PE, trusts want to combine retail investors with PE activity (unlike with closed-end funds). GPs create a trust with a term (the VCF term) and they set a portion of their assets in the trust which they use as a collateral to show the LPs the commitment in the management of the fund. Investors become the settlers, whereas a management company becomes the trustee. The trust does not own any assets, rather it just has the cash injected by the investors used to make VC investment.

66

VCF

VCT

Banks

Business Angeles

Local PPP

8

Venture Capital Trust: Application in PE TRUST Debt Investors (Settler)

cash

Cash

Investors (99%)

Equity Management Company (1%) Investment 1

Management Company (Trustee)

Investment 2 Investment n

67

VCF

VCT

Banks

Business Angeles

Local PPP

8

Venture Capital Trust: Application in PE Every time investors invest in trust, they receive a certificate listed in the stock exchange; this ensures to investors a high level of liquidity. The trust is like “an empty box” that does not publish any financial reporting. The investors trust the reputation of the trustee.

A trust can invest in listed securities, but at least 70% of the cash collected among the retail investors must be used to invest in non-listed companies. In the end, fiscal incentive are granted to the investors.

68

VCF

VCT

Banks

Business Angeles

Local PPP

8

The Other UK Players Local PPPs They are not as popular as they are in the US within SBICs. They operate at a local level and they do not have to comply to certain rules, rather they have to comply to local laws. Business Angels See the US’s case. Banks See the US’s case.

69

Content 1. 

Private Equity Investors: the Map to Investigate

2. 

Closed-End Funds in Europe: An Overview

3. 

Closed-End Funds in Europe: Lifetime of a Fund

4. 

Management Fees and Carried Interest

5. 

Investment Firms and Banks in Europe

6. 

Limited Partnerships in the US

7. 

The SBIC Experience in the US

8. 

Funds and VCT in the UK

9

9.  Understanding Taxation Around the World 10.  New Solutions: SPAC, Private Debt Fund, Venture Philanthropy, and Crowd Funding

11.  Calculating Returns (Exercise)

9

Taxation within PE After having seen the key elements of the different vehicles through which an investor can invest in PE, it is time to understand how the taxation works for these investments. To see how taxation works within PE, provided that taxation differs in every country, two are the perspectives: •  Players involved into taxation in PE •  Areas of impact on taxation Not every combination player-area of impact is relevant from the fiscal point of view. We will focus only on those combinations which are.

71

9

Taxation within PE Vehicles Taxation on capital Relevant to increase gains NAV and IRR Taxation on Relevant to increase dividends NAV and IRR

Investors Relevant for personal taxation profile (final net IRR)

Venture-backed Company Not relevant

Relevant only for gains given trough earnings

Not relevant

Not relevant

Not relevant

Relevant to reduce company tax rate

Incentive to R&D Not relevant investment

Not relevant

Relevant to reduce company tax rate

Comparative incentive D vs. E

Not relevant

Relevant to compose capital structure within net WACC

Incentive to startup

Not relevant

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9

Taxation on Capital Gains For the taxation on capital gains, there are two relevant players: the vehicles and the investors.

Taxation on Capital Gains for the VEHICLES Three standards may be applied: a)  Participation Exemption (PEX): It is a mechanism identifying a threshold in the taxation. When some conditions occur, the tax burden on the vehicle is lower than the general taxation in the country. b)  Flat tax: It works like the PEX, only without any conditions. The tax rate is lower that the tax rate in the country (like for Close-end Funds in Europe for which the tax rate is 20%). c)  Tax Transparency: This is a special case of flat tax making the tax rate equal to 0%. Plus this entails that losses can be deducted as if they were costs. Regardless of the tax transparency on the vehicle, the investors have to pay taxes in their home country (this is the case of VCF both in the US and in the UK and of SBICs). 73

9

Taxation on Capital Gains Taxation on Capital Gains for the INVESTORS

In this case, the tax burden derives from a mix of the fact that an investor is either a domestic or a foreign investor (with respect to the vehicle) and if the investor is a legal entity or a private individual. You will have 4 different combinations as reported in the matrix below, whose content will differ by country. Domestic

Foreign

Private individual Legal Entity 74

9

Taxation on Dividends For the taxation on capital gains, there are two relevant players: the vehicles and the investors.

Taxation on Dividends In this case, the rules that are applied to investors and to vehicles concerning the taxation on dividends are the same as in the case of capital gains. Although, one very important difference between this case and the previous one stands in the fact that dividends are not the primary goal of the PE activity, the generation of capital gain is.

75

9

Incentives to R&D and Startups Concerning the fiscal incentives to undertake R&D activities and to invest in startup, there exists three mechanisms, relevant only to VBCs.

Three incentives (from the least to the most sophisticated): a)  Mark Down: The tax rate is reduced to incentivize these investments without any parameter of investment (e.g.: in the first three years of a startup, the company does not have to pay taxes.). The risk is that such a mechanism can create vicious cycles. b)  Shadow Costs: The company can use some debt expenses to generate tax benefits. c)  Tax Credit: This is a tax voucher that the company can use in other fiscal years.

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9

Taxation and Incentives to D/E Ratio Concerning the fiscal incentives to the D/E ratio, there are two mechanisms relevant to the VBCs only. Two incentives a)  Thin Cap: There is a limit for the company to use interest rate paid on debt to reduce the fiscal burden. b)  DIT: Double Income Taxation gives tax incentives if the company collects money trough equity.

77

Content 1. 

Private Equity Investors: The Map to Investigate

2. 

Closed-End Funds in Europe: An Overview

3. 

Closed-End Funds in Europe: Lifetime of a Fund

4. 

Management Fees and Carried Interest

5. 

Investment Firms and Banks in Europe

6. 

Limited Partnerships in the US

7. 

The SBIC Experience in the US

8. 

Funds and VCT in the UK

9. 

Understanding Taxation Around the World

10

10.  New Solutions: SPAC, Private Debt Fund, Venture Philanthropy, and Crowd Funding 11.  Calculating Returns (Exercise)

10

New Trends in PE Innovation in the instruments and mechanisms of financing is very important in PE. As a matter of fact, the market signals and trends stimulate new solutions in the way of doing PE. Nowadays, there is the definition of 4 new solutions: 1)  Private Debt funds 2)  Crowd Funding 3)  Venture Philanthropy 4)  Special Purpose Acquisition Companies (SPACs)

79

10

1. Private Debt Funds Vehicles used in private debt are the same as in private equity (investment firms, closed-end funds,…). The only difference is that the investment is made in private debt. This new instrument is becoming more and more popular lately for two reasons: 1)  In Europe there is an increasing tendency among companies to collect debt. Companies do not want to do so anymore with banks but through the market. For the companies listed this is easy: they issue bonds on the market. However in Europe most companies are not listed SMEs. 2)  PE already knows how to deal with the fundraising when the company is a private one.

80

10

2. Crowd Funding Crowd funding has become very important and widespread nowadays. It is a brand new and digital way of collecting money. Different players can launch their own financial needs and make a call on the internet to collect money through their platform. PE and VC can be done through crowd funding: for companies who are in the very early stages of their life, they launch a call on the market to raise money. Because this is a very recent approach, we can not say with certainty whether this tool works or not for startups.

81

10

3. Venture Philanthropy When PE vehicles invest only in businesses generating a string social impact, this is called Venture Philanthropy. In these cases, the mechanisms are the same as in the other forms of PE except for the fact that both investors and the management company accept to get a lower level off profits in terms of capital gains, carried interest, and management fees.

82

10

4. SPACs SPACs were born around ten years ago in the US and the idea was so successful that they started to operate in Europe 3-4 years ago. They basically are an “empty shell” a form of an SPV. 20% of the SPV vehicle is held by the promoter, the company is listed in the Stock Exchange so that they can collect the other 80% of the equity. The SPAC can collect money only to do one investment: to buy another company. If the SPAC succeeds, it will merge with the target company, otherwise the investors will get their money back as this is a “one-shot vehicle.”

83

Content 1. 

Private Equity Investors: The Map to Investigate

2. 

Closed-End Funds in Europe: An Overview

3. 

Closed-End Funds in Europe: Lifetime of a Fund

4. 

Management Fees and Carried Interest

5. 

Investment Firms and Banks in Europe

6. 

Limited Partnerships in the US

7. 

The SBIC Experience in the US

8. 

Funds and VCT in the UK

9. 

Understanding Taxation Around the World

11

10.  New Solutions: SPAC, Private Debt Fund, Venture Philanthropy, and Crowd Funding

11. Calculating Returns (Exercise)

11

Introduction This exercise aims at understanding, in practice, how the calculation of carried interest and of management fees work for a closed-end fund managed by an AMC. The exercise will be done following these steps: 1)  Presentation of the inputs 2)  Investment: presentation on the cash flows deriving from the investment and in the divestment phases 3)  Computation of the IRR In doing the exercise, we have to remember the formula used in module2 clip4 to calculate the Carried interest:

CARRIED INTEREST = % x (Final IRR – Hurdle IRR)

85

11

Inputs INPUT

The committed capital is the size of the closedend fund.

Management Fee

2%

Hurdle Rate

8%

Carried Interest

30%

Committed Capital (min.)

400

Percentage Managers (GPs) The percentage is fixed by law.

2%

OUTPUT Committed Capital Capital at the End

400 ?

86

11

Investment To apply the carried interest formula and to compute the remuneration of the managers, we need to calculate the development of the investment of the closed-end fund. Investment period

Divestment period

extra

Draw-downs

Years

1

2

3

(+)

Draw-downs

100

200

100

0

0

0

0

0

0

0

400

(-)

Investment

80

190

130

180

310

360

100

200

50

0

1600

(+)

Divestment

0

0

40

200

320

370

100

250

500

600

700

3080

(-)

Management fee

8

8

8

8

8

8

8

8

8

8

8

88

12

14

16

28

30

32

24

66

508

1100

1792

Cash

4

5

6

7

8

9

10

11

Total

Final amount of the closed-end fund (starting from 400)

2% x 400

Note that in the 10th and 11th year no investment is planned. The focus is on the exit.

Maturity 87

11

Case 1: Global IRR We have to understand how to split the total amount of the closed-end fund. The formula can be applied in two ways even if the formula is the same: in the first way, the carried interest is computed on a global level (global IRR approach) whereas in the second way, the carried interest is computed on a yearly basis (yearly IRR approach).

STEPS Fund Global IRR

348%

Net Global IRR

340%

Carried Interest

102%

For Managers (GPs)

408

For Investors (LPs)

1384

a)  The global IRR of the fund: (Final Amount – Committed Capital) Committed Capital

b)  Net global IRR: Global IRR – Hurdle Rate

c)  Carried Interest: Net Global IRR * Carried Interest 88

11

Case 1: Global IRR We have to understand how to split the total amount of the closed-end fund. The formula can be applied in two ways even if the formula is the same: in the first way, the carried interest is computed on a global level (global IRR approach) whereas in the second way, the carried interest is computed on a yearly basis (yearly IRR approach).

Fund Global IRR

348%

d)  The remuneration for the managers:

Net Global IRR

340%

Carried Interest * Committed Capital

Carried Interest

102%

e)  The remuneration for the investors:

For Managers (GPs)

408

For Investors (LPs)

1384

Total Amount – Managers’ Remuneration

Remember that managers invested 2% of the committed capital, whereas investors invested 98% of it. 89

11

Case 2: Yearly IRR We are approaching the yearly way to compute IRR. STEPS a)  The IRR of an investment planning to invest € 400 million in time 1 and receiving €1,792 million euros is equal to 16.2%. b)  Net yearly IRR: Fund Yearly IRR

16.2%

Net Global IRR

8.2%

Carried Interest

2.45%

Fund Yearly IRR – Hurdle Rate

c)  Carried Interest: Net Yearly IRR * Carried Interest

For Managers (GPs)

122.2335

d)  The remuneration for the managers:

For Investors (LPs)

1669.766

Carried Interest * Committed Capital

e)  The remuneration for the investors: Total Amount – Managers’ Remuneration 90

11

Final Considerations Note that in both cases we have used the formulas without catch up. This means that the carried interest is calculated on the difference between the final IRR and the hurdle rate. It is possible, on the contrary, to calculate the same results also with catch up and this means that the carried interest is calculated not on the difference but on the IRR of the fund.

91

MODULE 3

PRIVATE EQUITY AND VENTURE CAPITAL By Professor Stefano Caselli Università Bocconi and SDA Bocconi

Content 1.  The Managerial Process for Equity Funds 2.  Fundraising 3.  Investing: The Decision Making Phase 4.  Investing: The Deal Making Phase 5.  Managing and Monitoring: Supporting the Company 6.  Managing and Monitoring: Covenants Usage 7.  Exiting 8.  Private Equity Advice for Entrepreneurs – Interview with Fabio Sattin

1

1

Introduction In the previous week we saw: §  The different formats in which an investor can invest in PE §  The different regulations and fiscal frameworks for the players involved in the PE activity This week is concentrated on the management of private equity and venture capital funds. After an overview of the managerial process of an investor we will, in detail, see the four different steps of this process.

3

1

The Managerial Process Equity investments can be developed through different vehicles and each operate with a different legal entity, even if the most popular are limited partnerships, investment firms and closed-end funds. Even if vehicles are different, managerial practices and typical phases of activity are very similar. As a matter of fact, the functioning is based on two different players: Managers and investors.

For this reason, it is important to understand the different aspects of the Managerial Process of private equity.

4

1

The Managerial Process The managerial process is the day-by-day activity of the managers managing the investment made by the investors. When highlighting the characteristics of the managerial process, both academia and practitioners consider this process as made up of four steps: 1)  2)  3)  4) 

Fundraising Investment activity Managing and Monitoring Exiting

For each phase there is also a different contribution coming from the management themselves, the advisory and the board of directors.

5

1

Fundraising This first activity of fundraising is included in the managerial process even if this activity starts before the vehicle is launched. The fund-raising activity is devoted to promote the business idea of the new vehicle of equity in order to find money. It is in fact a very preliminary activity (Note: remember that in Closed-End Funds this activity occurs before time 0?) occurring before the actual starting of the investment. In the case of the Closed-End Funds this takes 1.5 years, whereas for VCF this phase takes 1 year. If managers are able to collect the whole investment and they are able in this way to get to time 0, the legal entity starts its activities and then the other three activities (investment, managing and monitoring, and exiting) start.

6

1

Investing, Managing & Monitoring, Exiting When the fundraising phase comes to an end, the other three phases start. In the ordinary activity the managers have to decide the investment policies and the investment target; at the same time they manage and monitor the company in which the investment is made; and, at the same time, they have the exiting issue; that is they have to understand when (and if) they will be able to exit.

The exiting moment is in the end the reason why managers do PE activities.

7

1

Investing Investing is the mission of the equity investment vehicle to create value for the investor through the scouting, the screening, the choice, the managing and the exiting of ventures. From when they decide to invest, managers have two problems: on the one hand, they have to valuate the company in which they invest; and on the other hand, when managers and GPs decide to invest they have to negotiate the mechanisms supporting their management of the company. If the decision of the investment is made, the managerial process enters another phase: The management and monitoring phase.

8

1

Managing & Monitoring Managing and monitoring activities concern the involvement of the vehicle in the selected ventures. These two activities have to ensure the creation of value and to control the opportunities for the financed venture. When in this phase, the PE is a shareholder because the PE decided to invest in the VBC. The managers have to support and sustain the company in the ordinary activity. For the managing and monitoring to be successful, the last phase has to come.

9

1

Exiting Exiting concerns the decision to sell the equity owned in the portfolio in order to have a gain. This single decision has to be planned with a broad portfolio vision. For this to happen, the PE has to identify another shareholder to which they sell their stake of the company. Because the liquidity is very low, finding a counterpart is not easy. This is the most important phase, because it is only with the exiting that the PE is able to exit the investment and generate a capital gain (i.e. an IRR for the PE investor).

10

Content 1.  The Managerial Process for Equity Funds

2.  Fundraising 3.  Investing: The Decision Making Phase 4.  Investing: The Deal Making Phase 5.  Managing and Monitoring: Supporting the Company 6.  Managing and Monitoring: Covenants Usage 7.  Exiting 8.  Private Equity Advice for Entrepreneurs – Interview with Fabio Sattin

2

2

Introduction This clip focuses on one specific step of the managerial process: The fundraising phase. This phase occurs before time 0, since it is the phase in which the PE firm has to gather the investors that want to invest in the funds. This is a very hard phase for the PE. The managers have to convince the investors of their idea: as a matter of fact, the investors will remain in that project for a very long time (think of a Closed-end fund whose length is ten years).

12

2

Fundraising Steps In the fundraising phase the management company has to sell the proposal launched to the market. The proposal is basically a business idea that leads to the creation of a vehicle to invest in private equity to produce value that will be spread among the promotersmanagers and the investors. Fundraising is a selling game in which reputation, mutual trust, and love for risk are the pillars. As a matter of fact, the success of the fundraising phase depends on the reputation of the management company: The better it is, the easier this phase becomes.

13

2

Fundraising Steps II The typical fundraising activity steps are as follows: 1.  2.  3.  4. 

Business Idea Creation Job Selling Raising Debt Closing

Of course, depending on the country and on legal framework, these activities can be partially or totally driven by law.

14

Business Idea Generation

Job Selling

Raising Debt

Closing

2

1. Business Idea Creation Business idea creation is aimed at producing an information memorandum to be promoted in the market. Before an information memorandum is produced “testing the waters” occurs. This phase is carried on in a very informal way among the professional network of the PE firm to assess, for instance, whether it makes sense for PE investors to invest in a specific cluster of PE or not. After the managers have received an informal consensus about their activity, a more formal part begins and the information memorandum is produced. The information memorandum has to explain the rationale of the business idea to the business community (and to the supervisors, in case the fundraising occurs in Europe) and has to appeal to the potential audience of investors. The success of the involvement of an investor into the business idea is strictly linked to the reputation and to the track record of the promoter.

15

Business Idea Generation

Job Selling

Raising Debt

Closing

2

1. Business Idea Creation II The typical content of an information memorandum is as follows: •  Choice of the vehicle •  Target to invest (countries, sectors, life cycle stages) •  Size of the vehicle and minimum amount at which the fund will be closed •  Corporate governance rules (i.e. relationship between promoters-managers and investors) •  Size and policy of investments •  Internal code of activity / LPA •  Track record of the promoters-managers •  Usage and size of leverage (in the case of a non-European fund) •  Costs

16

Business Idea Generation

Job Selling

Raising Debt

Closing

2

1. Business Idea Creation III When this step comes to an end, there are two options depending on the countries in which a PE firm operates.

If the PE firm operates in Europe, the PE must obtain the formal approval from the Supervisor and afterwards, the information memorandum is transformed into an internal code of activity.

In the US and in the UK, the PE firm does not have to obtain any approval, rather the information memorandum can be transformed in the LPA since it is a contract.

17

Business Idea Generation

Job Selling

Raising Debt

Closing

2

2. Job Selling Job selling is the phase in which the managers have to convince the investors not only to give an opinion about the idea, but also to invest in that idea. This is actualized by the letter of commitment with which the investors declare how they want to participate in the fund. This phase often occurs via one-to-one meetings between the promoters and the potential counterparts (may it be an insurance company, a bank or a high net worth individual). In some other cases, this phase may be organized in a kind of meeting, in which more than one investor is involved.

18

Business Idea Generation

Job Selling

Raising Debt

Closing

2

3. Debt Raising This phase only occurs if the fund is based either in the UK or in the US.

Debt raising is job selling too, but with a different perspective in which the goal is to sell a project to a community of financers. Debt raising is strongly related to the reputation both of the promoter and of the investors (good signaling effect). In fact this step is difficult for each counterpart (the investors and the banks) because no one wants to make the first move.

19

Business Idea Generation

Job Selling

Raising Debt

Closing

2

4. Closing After all the steps are concluded, whether the fund is located in the Englishspeaking countries or in Europe, the closing phase starts. The closing phase can be meant in two ways: §  A “successful” closing occurs when the PE firm is able to collect all the money necessary to begin the PE activity and this was possible thanks both to the reputation and to the purpose of the initiative §  A “pure” closing occurs when the PE firm is not able to collect the whole money in the fundraising phase. Such is the case when the managers do not have a very robust network.

20

Content 1.  The Managerial Process for Equity Funds 2.  Fundraising

3.  Investing: The Decision Making Phase 4.  Investing: The Deal Making Phase 5.  Managing and Monitoring: Supporting the Company 6.  Managing and Monitoring: Covenants Usage 7.  Exiting 8.  Private Equity Advice for Entrepreneurs – Interview with Fabio Sattin

3

3

Introduction This clip and the following focuses on another step of the managerial process: The investing phase. After the money has been collected by the PE firm, the phase of investing activity can start. The investing activity is the core of private equity business and it is the main way to develop the business idea for the managers on the investors’ behalf.

22

3

Investing Investing is a very broad definition, in which we can distinguish two different important moments: 1.  Decision-Making: the activity of valuation and selection in which the PE has to assess whether the investing activity makes sense. 2.  Deal-Making: the activity of negotiation of the contracts by which the PE firm can invest and actively participate in the company. These contracts include, for instance, the calculation of the shares the investor has to buy, the corporate governance rules…

23

Decision Making

3

Deal Making

Decision Making Decision making is the capability to understand the market and to pick up the right opportunities. This activity is made up of different steps: Origination Screening Valuation and due diligence Rating assignment Negotiation

As the process goes on, and the PE goes towards the decision to invest, both costs and commitment of the PE firm increase.

Decision to invest

The decision making process involves all of the players: the management company, the technical committee, and an advisory company. This path is sequential and the PE needs a green light in every step to move on to the next step.

24

Decision Making

Deal Making

3

Origination In this phase the PE must decide the destination of the money collected. It is based on two different drivers: some part of the origination is spontaneous, as you are a PE investor and the whole system knows that you have collected so much money and that you are looking for a company in which to invest. This is why, the PE firm has to screen a considerable amount of incoming proposal. On the other hand, origination is based on a proactive activity. This means that the managers have to scout the market and find the most suitable solution. This can be done through the other players (the technical committee and the advisory board) who can also help and scout the market.

25

Decision Making

Deal Making

3

Screening After the origination step, the screening step starts. In this phase about 90% of the dossiers collected in the origination step will be eliminated (note: remember the 100/10/1 rule in startups?). The screening is driven by the managers together with the technical committee. The output of the screening is a very small number of dossiers which the PE firm can further investigate and study deeply.

26

Decision Making

Deal Making

3

Due Diligence and Valuation This phase is the analysis of the business plan which starts right after the screening phase; since it takes a very long time if done right, the PE should do it only for a very narrow number of companies. This phase is dedicated to exclude the proposals that do not make sense for an investor. The outcome of due diligence is a small number of proposals which it makes sense to undertake the rating assignment for.

27

Decision Making

Deal Making

3

Rating Assignment In this phase the PE rates and grades the dossiers of the different companies. This is fundamental to assess the level of risk and is important to understand if (and how) the PE firm has to collect funds through debt. For instance, assessing the level of riskiness and of indebtedness during an LBO in which an SPV has to be financed using debt is of primary importance. If the level of risk is too high after the rating assessment the deal can not be taken further.

28

Decision Making

Deal Making

3

Negotiation Negotiation is not based on the deal design, but it is the negotiation with the entrepreneur to calculate the numbers of shares a PE owns and the stake to which they correspond in terms of equity. In this phase the PE understands if there is room for an external shareholder.

29

Decision Making

Deal Making

3

Decision to Invest The managers (the GPs or the directors in an AMC in Europe) have to convince the whole Board of the PE firm if it is worth to invest in that specific company.

The decision of investing does not mean to invest immediately in the company, rather it sets the beginning of the second part of the investing phase: Deal making.

30

Content 1.  The Managerial Process for Equity Funds 2.  Fundraising 3.  Investing: The Decision Making Phase

4.  Investing: The Deal Making Phase 5.  Managing and Monitoring: Supporting the Company 6.  Managing and Monitoring: Covenants Usage 7.  Exiting 8.  Private Equity Advice for Entrepreneurs – Interview with Fabio Sattin

4

4

Introduction This clip deals with the second part of the investing phase: Deal making. In the first part of the investing phase, the managers of the PE firm decided to invest after the green light of the Board of the AMC or by the GPs. This second part concerns the deal making activity related to the financial and legal issues related to the investment in the venture-backed company.

32

4

Deal Making Deal making means setting up the contracts between the investors and the company in which they find the right balance between the need of money of the company and the expectation of IRR and capital gain for the PE investors.

Finding the right balance is not easy and the whole process is based on three pillars: 1.  Targeting 2.  Liability profile 3.  Engagement

33

Targeting

Liability Profile

4

Engagement

Deal Making Vehicle

Targeting Amount of Shares

Contract Designing & Techniques of Financing

Liability Profile

Syndication Strategy Debt Issuance Categories of Shares

Engagement

Paying Policy Governance Rules 34

Targeting

Liability Profile

Engagement

4

Targeting Targeting is based on two decisions that must be negotiated with the company. 1.  The vehicle in which the PE firm invests 2.  The percentage of shares the PE gets 1. The Vehicle This is the valuation of either a direct investment or in an indirect investment (with the SPV). The rationales of a direct investment may be among others: the business is totally interesting for the investor; the control is complete; the commitment between investor and company is high and exclusive. The rationales of a SPV creation may be among others: the investor pays only the relevant assets; the investment is tailor-made on the business plan. Remember that this entails the use of leverage, therefore the PE firm has to convince the banking system too.

35

Targeting

Liability Profile

Engagement

4

Targeting 2. The Amount of Shares This negotiation follows the decision taken in the previous step (i.e. the PE firm decided the vehicle through which it will make its investment). This step concerns the decision of the percentage of shares the PE has to buy and the role it will have within the company equity. There are some key points to be addressed: •  Majority versus minority •  Relative and absolute size of investment •  Capital requirement impact •  Voting rights and effective influence within the board of directors

36

Targeting

Liability Profile

Engagement

4

Liability Profile The liability profile, as the name itself suggests, involves the decision concerning the liability side of the company. Again, there are two decisions a PE firm needs to make… First choice: The Syndication Strategy It concerns the decision to find other equity investors with whom build a syndicate to invest together. At first sight, this decision may sound unfair due to the huge amount of time the PE firm dedicated to the screening and to get to the final decision. Actually, this may be helpful to multiply the investment power and in this way, they could share the risk borne otherwise only by the PE firm.

37

Targeting

Liability Profile

Engagement

4

Liability Profile Second choice: Debt Issuance It concerns the decision to combine equity investment (with or without SPV, syndicated or not) with the usage of leverage, this entails a very hands-on approach towards the venture-backed company. This decision is related to the debts of the venture-backed company whether they be issued with bonds or obtained through loans and mortgages. In the latter case, this means that the PE firm will have to negotiate with the banking system.

38

Targeting

Liability Profile

Engagement

4

Engagement The third pillar of deal making concerns the engagement: in this moment the PE firm has to set up the rules by which a PE can govern the venture-backed company. This pillar is made up of three activities. Categories of Shares It concerns the choice of the shares the PE has to buy in order to guarantee the best way to develop the investment and the following managing phase. Typical choices concerns: •  Common shares •  Shares with limited or increased rights •  Shares with embedded option: for instance a share with a put option allowing the PE to sell the shares under some particular circumstances •  Tracking stocks This decision has to be coordinated with the different classes of debt in case of leverage. 39

Targeting

Liability Profile

Engagement

4

Engagement Paying Policy This concerns the questions a PE firm needs to address related to the fact that a PEI is buying another company’s shares. The most important questions that need to be answered in this step are: •  Does the PEI need to buy new shares or can it buy also pre-existing shares? •  What’s the expectation of the entrepreneur? (to gain money or to have support) •  What’s the relationship between the PEI and the existing shareholders?

The main activity of a PEI is to finance a company. In some cases if the entrepreneur is important, or in case he or she has a very strong contractual power, the PEI may have to buy some of the entrepreneur’ s shares as well. 40

Targeting

Liability Profile

Engagement

4

Engagement Governance Rules It is the negotiation of the functioning of the board to ensure the capability of the PE to interact the company in the best way as possible. Some among the most discussed issues in this activity are: •  Numbers of directors •  Can the PEI sitting on the board of directors •  The scheduling of the board meetings

41

Content 1.  The Managerial Process for Equity Funds 2.  Fundraising 3.  Investing: The Decision Making Phase 4.  Investing: The Deal Making Phase

5.  Managing and Monitoring: Supporting the Company 6.  Managing and Monitoring: Covenants Usage 7.  Exiting 8.  Private Equity Advice for Entrepreneurs – Interview with Fabio Sattin

5

5

Introduction This clip deals with the third part of the managerial process: Managing and monitoring. The PE company is one of the shareholders and at this moment the investor has a conjoint aim: they want to enhance the value of the company as much as possible and at the same time they want to find another buyer in order to exit and get their capital gain.

43

5

Managing and Monitoring Actions to create and to measure value

Managing & Monitoring

Mitigate divergences of opinions and avoid conflicts between the PE and the entrepreneur

Rules to protect the created value

44

Actions to create value

Rules to protect value

5

Actions to Create Value Typically the actions taken are dedicated to qualify the presence of the investor within the managerial process of the venture backed company. The nature of this presence depends on: §  The stage of the investment §  The style of the investor and the nature of the investment agreement In the first case, if we consider the stages of investment moving from the seed to the replacement financing, the involvement of the investor is decreasing (even if in the vulture case the involvement is equal to the one in seed financing). Both in seed and start up, the involvement could be even industrial and strategic, while in expansion and replacement the support coming from the investor could be reduced simply to advisory within financial and legal issues.

45

Actions to create value

Rules to protect value

5

Actions to Create Value II Concerning the style of the investor and the nature of the agreement signed between the venture capitalist and the venture backed company, it is generally characterized by two different profiles: §  The hands-on approach §  And the hands-off approach Hands-on stands for a deep involvement both in corporate governance and in financial and strategic decisions; hands-off stands for a presence in the corporate governance and involvement only in financial decisions.

46

Actions to create value

Rules to protect value

5

Actions to Create Value III Regardless of the stage of life and the involvement of the PE firm, the key activities that a PEI takes in order to create value are: •  Board services •  Performance evaluations and reviews •  Recruitment management •  Assistance with external relationships •  Helping to arrange additional financing •  Mentoring

47

Actions to create value

Rules to protect value

5

Actions to Create Value IV Board Services Performance Evaluations and Review

Active participation in the life of the company with the provision of the proper corporate governance. Creation of value means to support decisions, introduce professional expertise, and impose a severe discipline. There is only one case in which this action is not necessary: when the exit occurs through a put option with a bank. Development of all the required processes to monitor and measure value inside the company and between the company and the investor (in terms of accountability, auditing, IT systems…).

Recruitment Management

The management team could be not adequate in terms of skills. The investor’s support is crucial to choose, from the marketplace, the right people to hire; this is particularly true both for start ups and for SMEs.

Relationship Management

Both current and strategic activities can benefit from the network of the investor (customers, suppliers, governmental lobbying, …).

Mentoring

The PE has to be completely and fully available for the entrepreneur 24/7. the entrepreneur expects the PEI’s support to make decisions at any moment. This activity concerns “soft assistance” in terms both of technical and personal support to the management and to the entrepreneur (or shareholders).

48

Content 1.  The Managerial Process for Equity Funds 2.  Fundraising 3.  Investing: The Decision Making Phase 4.  Investing: The Deal Making Phase 5.  Managing and Monitoring: Supporting the Company

6.  Managing and Monitoring: Covenants Usage 7.  Exiting 8.  Private Equity Advice for Entrepreneurs – Interview with Fabio Sattin

6

6

Introduction This clip deals with the other side of managing and monitoring. Besides the creation of value, the PEI has to deal with the protection of such value: the second moment of the managing and monitoring activity. These actions are taken in order to protect the divergence of opinions between the entrepreneur and the PEI and the risk of struggle that may derive from it. These are rules for the VCB and the PEI to live together in a temporary (albeit very important) “marriage.”

50

6

Managing and Monitoring Actions to create and to measure value

Managing & Monitoring

Mitigate divergences of opinions and avoid conflicts between the PE and the entrepreneur

Rules to protect the created value

51

Actions to create value

Rules to protect value

6

Actions to Protect Value II The typical covenants are as follows: 1.  Lock up 2.  Permitted transfer 3.  Staging technique 4.  Stock option plan 5.  Callable and puttable security 6.  Tag along rights 7.  Drag along rights 8.  Right of first refusal 9.  Exit ratchet

52

Actions to create value

Rules to protect value

6

Actions to Protect Value III Lock Up

A covenant between the investor and existing shareholders that forbids both existing shareholders and PEIs from selling for a certain period.

Permitted Transfer

This is a kind of more sophisticated lock up. It is an agreement between the investor and existing shareholders that prohibits both existing shareholders and PEIs from selling without the approval of the other.

Staging Technique

The injection of capital occurs in installments, with a financial target to be met before the next installment takes place. This agreement helps ensure that the money is not squandered on unprofitable prospects.

Stock Option Plan

An option given to the management of the venture backed company to buy stocks at a favorable stock price. The provision generates commitment to create value.

Callable and Puttable Securities

The issuing of securities in which the PEI has the right to sell the stocks to the existing shareholders (puttable) and the existing shareholders have the right to buy the stocks from the PEI (callable). In both cases, the option scheme can be: American or European (i.e., without or with a specific data to exercise the right) and single or combined (i.e., only callable or puttable, or callable and puttable together).

53

Actions to create value

Rules to protect value

6

Actions to Create Value IV Tag-Along Rights

A contractual obligation used to protect the minority private equity investor. In case the majority shareholders sells the stake, then the PEI has the right to follow the transaction and sell its minority stake on the same conditions and to the same buyer that is buying the majority stake.

Drag-Along Rights

A contractual obligation used to protect a majority PEI. With this agreement, in case the PEI sells the stake it has the right to ask the shareholders to sell their stake at the same conditions and to the same buyer. It is a mechanism to maximize the price of the sold shares: the PEI has the possibility to sell 100% of the company without owning it and when you can sell the whole company, you have a higher contractual power.

Right of First Refusal

A provision by which the PEI can avoid the shareholders selling their stake to undesired shareholders. In this case, the PEI has to buy the stake of the selling shareholders at the same conditions offered by the potential buyer.

Exit Ratchet

A provision by which the “remaining” shareholder has the right to obtain a percentage of the capital gain deriving from the sale of the shares. This applies both to the PEI and to the entrepreneur.

54

Content 1.  The Managerial Process for Equity Funds 2.  Fundraising 3.  Investing: The Decision Making Phase 4.  Investing: The Deal Making Phase 5.  Managing and Monitoring: Supporting the Company 6.  Managing and Monitoring: Covenants Usage

7.  Exiting 8.  Private Equity Advice for Entrepreneurs – Interview with Fabio Sattin

7

7

Introduction In this clip we will deal with the last step of the managerial process of PE: Exiting. This is the moment in which the PEI understands if (and how much) value has been created by the VBC. Exiting is the most difficult step for a PEI, because there exists both a pricing and a liquidity issue.

56

7

Exiting The exiting activity concerns the decision to sell the stake in order to gain the value created through the investment and the managing & monitoring of the venture. Exiting strategies have to be contextualized according to the portfolio strategy of the PEI. There is in fact a double perspective where the IRR of the investment has to be coordinated with goals and constraints coming from the whole portfolio.

57

7

Exiting II Exiting has to be coordinated with: •  The specific rules and covenants of the investment •  The timing opportunity driven by the company’s business •  The timing opportunity driven by the financial market •  The capital requirement and pricing constraints •  The track record of exiting in the portfolio of the PE firm Equity investments are made up of different clusters (i.e., seed, start up, expansion, replacement, vulture) but theory and market trends show there is no correlation between: the stage of investment, the holding period and the exit way strategy. This suggests that each case has to be analyzed per se

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7

Exiting III The typical exiting strategies are the following: 1.  Trade sale 2.  Buy back 3.  IPO or sale post IPO 4.  Sale to other private equity investors 5.  Write off Even if in many investments the agreement for the exiting is clearly defined ex ante, only the development of the investment itself can tell the right choice of an exiting strategy.

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7

1. Trade Sale Trade sale is the exiting in which the private equity investor sells its stake to another corporation or to another entrepreneur. This exiting strategy is based on the industrial relation between the private equity investor, the buyer, and the venture backed company. The purpose of a trade sale is generally an acquisition to develop a strategic business plan from the buyer and for that reason trade sale can be developed through different solutions. Anyway, this option is not very widespread because usually entrepreneurs do not want to share their company or their ideas with another company or worse, with another entrepreneur. They are common in two cases: in LBO and when the PE_ holds the drag along right and they sometimes can occur in PIPEs.

60

7

2. Buy Back Buy back is the exiting in which the private equity investor sells its stake to an existing shareholder or to a buyer chosen by the existing shareholders themselves. Buy back is a trade sale in which the buyer is not a new corporation coming from the market. It occurs when the shareholders who don’t want to leave the company call for the equity investor to sustain the business. One of the most used covenants in these cases is the puttable shares (the PE has the possibility to sell the shares back to the entrepreneur). This option to exit gives for granted the fact that the entrepreneur has got liquidity enough to buy the shares, otherwise a negotiation starts between the entrepreneur and the PE.

61

7

3. IPO This way out is the best option a PEI could ever dream of. In this way a PEI can maximize the capital gain; and this occurs only in 1% of the cases. Through an IPO, the private equity investor sales its stake in the stock exchange. That means that an IPO is the condition by which a PEI launches the sale but the mere sale can either occur during or after the IPO itself. In both cases, the private equity investor is strongly involved in the IPO process, acting either as a global advisor or as a manager. The different role depends on the nature of the private equity investor. An IPO is very difficult, though, because the company must be ready for it, the business of the company has to be attractive to be accepted and the entrepreneur has to be prepared to work and deal with retail investors. IPO launches follow the so-called “bubbles”. For instance, going back to early 2000s many IPOs took place.

62

7

4. Sale to Another Private Equity Investor

The sale to another private equity investor is the exiting in which the private equity investor sells its stake to another private equity investor. This exiting strategy is common in the American market and is based on strong relationship between the private equity investor and the community of private equity investors. Although this kind of exit is not that easy due to the fact that different PE investors have different goals: the first one wants to maximize the capital gain, whereas the second one wants to buy the participation at the lowest possible price (in order to maximize in the future the capital gain). The purpose of this sale is to sell the stake to an investor which operates in the following stage of investment (i.e., from seed to start up, from start up to expansion, etc…) so that the VBC is walked through its life cycle. 63

7

5. Write Off Write off is the exiting in which the private equity investor cancels the value of the stake in its portfolio; it is the worst nightmare of a PEI. This happens when the company defaults and this may occur in start up and seed financing because the business plan may be too aggressive. A write off does not necessarily mean an IRR -100% because the PEI may try to sell some valuable assets in order to recover from the loss. Write off process can be driven by a private agreement or by law (i.e. failure process).

64

Content 1.  The Managerial Process for Equity Funds 2.  Fundraising 3.  Investing: The Decision Making Phase 4.  Investing: The Deal Making Phase 5.  Managing and Monitoring: Supporting the Company 6.  Managing and Monitoring: Covenants Usage 7.  Exiting

8.  Private Equity Advice for Entrepreneurs – Interview with Fabio Sattin

8

8

Who Is Fabio Sattin? Founder of a Private Equity Firm: Private Equity Partners Chairman of the EVCA in the past Professor of “Private Equity and Venture Capital” at Bocconi University

8

Q&A Let’s focus on PE in continental Europe where the minority investments are very popular and are a means to make the company grow. This means that the entrepreneur and the investor have to work together. What are the suggestions for an entrepreneur who has to work with a PE investor? “The chemistry and the personal relation between the PE and the entrepreneur is fundamental to make the partnership successful. Suggestions? In the first place, the basic decision: the entrepreneur has to understand that he/she needs a partner, not just a cash injection. The entrepreneur has to be open to share his/her decisions and to be transparent about the problems. In addition, an entrepreneur has to select the right PE firm for the specific needs. Besides the PE firm, the entrepreneur has to pick the right person for this person will be actively involved in the ordinary life of the company. In the end, the entrepreneur has to understand the decision-making process of the partner (either local or international). Depending on the needs, a local partner may be more suitable than an international one, or the other way around. Also, the business model is an aspect the entrepreneur needs to understand (some PE may be more keen on IPO, rather than trade sale…). Throughout the deal, the entrepreneur has to remember that the PE is an investor that does not just provide money.

8

Q&A Sometimes there may be an overlap between management and when a PE invests in a company. How do you think it is possible to work together and successfully within this interaction? “This is a very crucial aspect, especially for Europe. When an entrepreneur opens the equity to a PE investor, the entrepreneur needs to remember that the company will still be managed by the management team. If an entrepreneur is not ready to distinguish her role and the managers’ role, this means this in not the right time to open to PE. The entrepreneur has to bear in mind that if he/she decides to open to PE, she will have to accept the decisions taken by the PE. Again, the entrepreneur has to be able to delegate the decisions to the management, keeping under control the overall process. It is very important from both sides to be very clear and maybe to write down what the managers can or can not do, what the entrepreneur can or can not do.”

8

Q&A You said before that PE is like a marriage and we know that the IPO may be among the most wanted desires at the end of the marriage. How is it possible to regulate the marriage and the shared desire of an IPO? “Normally there is a pre-IPO deal. The picture of a PE investor investing as a minority shareholder for 3-4 years leading a company to be listed is the ideal picture. If this is the case, the parties need to regulate it from the beginning of the deal, including it in the terms and conditions. Also, it should be stated that all shareholders and the management team must take every decision with that final purpose borne in mind. Also, in the contract it should be defined when the IPO is supposed to take place and who is selling and who is not and whether there will be a capital increase. For instance, in my personal experience, we have rules since our first IPO with Natuzzi in 1993. When there is an IPO, we sell 2/3 of the stake on the day of the IPO and the remaining third of the stake after one year and this is made clear since day one. According to me, having rules is the best way to avoid misunderstandings.”

MODULE 4

PRIVATE EQUITY AND VENTURE CAPITAL By Professor Stefano Caselli Università Bocconi and SDA Bocconi

Content 1.  Company Valuation Fundamentals 2. 

Company Valuation Fundamentals: The Pillars of DCF

3. 

A Case of Company Valuation for PE Investment

4. 

Applying Company Valuation to PE Settings

5. 

Applying Company Valuation to VC Settings: The VC Method

6. 

Launching Your Own Startup: Suggestions

7. 

PE and M&A – Interview with Eugenio Morpurgo

8. 

PE and IPO – Interview with Luca Peyrano

9. 

PE, Turnaround, and Restructuring – Interview with Raffaele Legnani

1

1

Introduction This week deals with the issue and concrete application of company valuation. This clip provides you with an overview of the fundamentals of company valuation, while in subsequent clips some specific valuation models will be focused on and their application to PE.

3

1

Company Valuation Company valuation is the assessment of company’s value. Concerning PE, company valuation is a fundamental step since the PEI needs to know the value of the company in which it is investing to decide to buy either newly issued shares or already existing.

4

1

Company Valuation The process of company valuation is the core of the investing phase. We will use corporate finance theory to do that. However, what is peculiar about PE is that equity has to be calculated in two different moments: § 

Time 0: The moment in which the PEI decides to invest and in which the PEI buys the shares of the private company

§ 

Time n: The moment when it exits These two moments are correlated and they are related to the generation of IRR. In the first moment you should minimize equity value, on the contrary at time n you have to maximize equity value. 5

1

Company Valuation: The Macro Components of a Balance Sheet Current Assets

Current Liabilities

Fixed Assets

NFP

Financial Investments

Other Liabilities

Intangible Assets

Equity 6

1

Equity Value: The Pillars for Company Evaluation The most popular way for calculating the equity value is represented by discounted cash flow (DCF), where the rationale behind this model lies the assumption that the value of the company is made up by the present value of the cash flows (CF) that the company will generate over the following years discounted at the weighted average cost of capital (WACC). How do you calculate CF for the following years? The PEI bases the estimation on a sound and reliable business plan.

7

1

Equity Value The general equation to calculate the equity value for an n-maturity perspective of investment is: n

Equity = t=1

CFt + TVn + (SA – M – NFP) t (1 + WACC) Enterprise Value

Where: •  TV is the terminal value at time n •  SA are surplus (non-operating) assets •  M represents the equity held by minority shareholders •  NFP is the net financial position •  SA, M and NFP refer (if they exist) to the time in which the valuation is made 8

1

Multiples At the same time, the multiples method is also very widespread. This takes into consideration the company together with its peers. For this reason, this method is used together with the DCF to develop a fine tuned valuation. The most used multiples are: •  EV/EBITDA •  EV/EBIT •  EV/S

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1

Multiples EV/EBITDA

Enterprise value/EBITDA gives a strong advice about “How many times do you have to multiply the EBITDA to buy the company?” It is based on the capability of the firm to produce gross margin.

EV/EBIT

Enterprise value/EBIT gives a strong advice about “How many times do I have to multiply the EBIT to buy the company?” It is based on the capability of the firm to produce operating profit.

EV/S

Enterprise value/sales gives a strong advice about “How many times do I have to multiply the sales to buy the company?” It is based on the capability of the firm to produce sales.

10

Content 1. 

2

Company Valuation Fundamentals

2.  Company Valuation Fundamentals: The Pillars of DCF 3. 

A Case of Company Valuation for PE Investment

4. 

Applying Company Valuation to PE Settings

5. 

Applying Company Valuation to VC Settings: The VC Method

6. 

Launching Your Own Startup: Suggestions

7. 

PE and M&A – Interview with Eugenio Morpurgo

8. 

PE and IPO – Interview with Luca Peyrano

9. 

PE, Turnaround, and Restructuring – Interview with Raffaele Legnani

2

Introduction After an overview of the DCF, in this clip we will individually analyze all the parts of the formula used to calculate the equity value, bearing in mind that the DCF is based on the generation of cash flow.

n

Equity = t=1

CFt + TVn + (SA – M – NFP) (1 + WACC)t Enterprise Value

12

Cash Flow

WACC

TV

NFP, M, SA

2

DCF The items composing DCF are the following: • 

Cash Flow

• 

WACC • 

kd

• 

ke

• 

TV

• 

NFP

• 

Minorities (M)

• 

Surplus Assets (SA)

13

Cash Flow

WACC

TV

NFP, M, SA

2

Cash Flow PROFIT AND LOSS (OR INCOME) STATEMENT + Sales and other operating revenues - Operating costs (including R&D) = EBITDA

à Gross margin

- Depreciation = EBIT + Other income

à Operating profit à Typically financial and not operating income

- Interest expenses = EBT - Income taxes = NET INCOME OR LOSS

14

Cash Flow

WACC

TV

NFP, M, SA

2

Cash Flow CASH FLOW EBIT - Income taxes + Depreciation - Increase in net working capital - capital expenditure

à CAPEX

= CASH FLOW This is the most widespread way to calculate the Free CF for the firm (i.e. the cash flow available for financers and shareholders without considering a new debt issuance and the old debt repayment). Some authors call it also “unlevered cash flow” or cash flow for the firm to highlight the fact that it does not provide any information about the capital structure. 15

Cash Flow

WACC

TV

NFP, M, SA

2

WACC The concept of cost of capital refers to: • 

Cost of debt (kd or id)

• 

Cost of equity capital (ke or ie)

That together are necessary to calculate the weighted average cost of capital (WACC).

16

Cash Flow

WACC

TV

NFP, M, SA

2

WACC: The Cost of Debt The cost of debt: id* = id (1 – t) Where: • 

id stands for the average weighted cost of capital calculated either by dividing the interest expenses by the financial liabilities or by taking into consideration every single rate referring to different financings.

• 

t stands for the corporate tax rate.

id* = interest rate net of taxes 17

Cash Flow

WACC

TV

NFP, M, SA

2

WACC: The Cost of Equity The cost of equity capital is calculated through the Capital Asset Pricing Model (CAPM) formula: ie = rf + β (rm – rf) Where: •

rf stands for the risk free rate (the rate of return yielded by a risk-free investment coherent in terms of maturity with the investment itself)

•

rm = rf + risk premium (i.e. the exceeding return investors expect from the market, measured with historical series, with respect to a risk-free investment)

•

β stands for the degree of correlation between the investment and the market

18

Cash Flow

WACC

TV

NFP, M, SA

2

WACC: The Cost of Equity The β coefficient of a stock is a regression of returns of the stock against the returns on a market index. When a company is not listed, it is necessary to compute the beta using the data of the comparable companies. Here follows the steps: 1)  Identification of the beta of a comparable (one or more) 2)  Deleveraging of the beta with comparable companies data 3)  Re-leveraging of the beta using the target company data Unlever means to exclude the effect of capital structure while relever means to recalculate the beta coefficient using the capital structure of the firm

19

Cash Flow

WACC

TV

NFP, M, SA

2

WACC: The Cost of Equity The procedure to unlever is:

βu  =  β/  [1+(1  –  t)(D/E)]   Where D and E are the market value of debt and equity of the chosen comparable companies. And the procedure to relever is:

β*  =  βu    x  [1+(1  –  t)(D/E)*]  

* = target company data 20

Cash Flow

WACC

TV

NFP, M, SA

2

WACC: The Cost of Equity Once equity and debt cost of capital have been computed, the WACC is:

 iWACC  =  id*    x    (D/D+E)  +  ie  x  (E/D+E)   Where WACC represents an effective measure of the cost of all liabilities for the company taken into consideration.

21

Cash Flow

WACC

TV

NFP, M, SA

2

Terminal Value The terminal value (TV) is a crucial item necessary to calculate the equity value. The formula is as follows:

TVn=

CFn x (1 + g) (WACC – g) (1 + WACC)n

Where g represents the perpetual growth rate by which the company is supposed to grow every year.

22

Cash Flow

WACC

TV

NFP, M, SA

2

Surplus Assets, Minorities, and NFP In the end, as seen in the previous clip, we need to deduct (if they exist): • 

Surplus Assets

• 

Minorities’ equity

• 

Net Financial Position

from the enterprise value in order to obtain the equity value.

23

Content 1. 

Company Valuation Fundamentals

2. 

Company Valuation Fundamentals: The Pillars of DCF

3.  A Case of Company Valuation for PE Investment 4. 

Applying Company Valuation to PE Settings

5. 

Applying Company Valuation to VC Settings: The VC Method

6. 

Launching Your Own Startup: Suggestions

7. 

PE and M&A – Interview with Eugenio Morpurgo

8. 

PE and IPO – Interview with Luca Peyrano

9. 

PE, Turnaround, and Restructuring – Interview with Raffaele Legnani

3

3

Introduction Through this exercise we will see the application of the equity value through the DCF. This set of slide presents the solution for the “Old Winery” case. Through this case a company valuation within PE is treated through a time horizon of four years. This means that the stream of CF has to be calculated over the whole investment period.

25

3

Inputs – Income Statement Income Statement (€/000): Data presented in the business plan

Sales Operating Costs

EBITDA Depreciation

-

EBIT Other Income Interest Expenses

-

EBT Taxes

NET INCOME

-

2015

2016

2017

2018

49,860 39,379

52,756 40,910

56,698 43,782

61,721 45,714

10,481

11,846

12,916

16,007

1,768

2,305

2,305

2,388

8,713

9,541

10,611

13,619

300

36

36

36

8,413

9,505

10,575

13,583

1,648

4,074

4,378

5,710

6,765

5,431

6,197

7,873 26

3

Inputs Inputs to compute the Cash Flow Statement (€/000): Data presented in the Business plan

2015

2016

2017

2018

1,768

2,305

2,305

2,388

(+)

Depreciation

(-)

Increase in the Working Capital

(-)

9,788

4,500

500

500

(-)

Capex

(-)

3,000

3,975

1,322

500

Comparable companies’ inputs

Mondavi (US) Beringer (US) Southcorp(AUS) Bodegas (SP) Campari (ITA) Antinori (ITA)

Beta

EV/Sales

EV/EBITDA

D/E

0.73 0.94 1.02 0.89 1.23 Not listed

6.2 5.5 8.5 8.5 6.7 4.9

26 22.9 24.9 26.7 24 26.9

9.45 5.25 8.25 8.35 7.35 7.85 27

3

Inputs

4

Expected Holding Period (n)

Other Necessary Inputs:

0.25%

g rate /g) Surplus Assets (SA)

12,000 -

Minorities (M) Net Financial Position (NFP)

10,000

The aim of the PE in this case is to compute the equity value through the formula: n

Equity = t=1

CFt + TVn + (SA – M – NFP) t (1 + WACC)

28

Cash Flow

WACC

TV

3

NFP, M, SA

Cash Flow Starting with the EBIT, we compute the CF for the period taken into consideration:

2015

2016

2017

2018

8,713

9,541

10,611

13,619

1,648

4,074

4,378

5,710

1,768

2,305

2,305

2,388

(+)

EBIT

(-)

Income Taxes

(+)

Depreciation

(-)

Increase net working capital

-

9,788

4,500

500

500

(-)

Capex

-

3,000

3,975

1,322

500

3,955

703

6,716

9,297

CASH FLOW

-

29

Cash Flow

WACC

TV

NFP, M, SA

3

WACC Following the steps in the WACC calculation, we need to compute: a.  Cost of debt net of tax

id*  =  id  (1  –  t)  

b.  β unlevered

βu  =  β/  [1+(1  –  t)(D/E)]  

c.  β relevered

β*  =  βu  [1+(1  –  t)(D/E)*]  

d.  Cost of equity

ie  =  rf  +  β  (rm  –  rf)  

e.  WACC

iWACC  =  id*    x  (D/D+E)  +  ie  x  (E/D+E)

30

Cash Flow

WACC

TV

NFP, M, SA

3

WACC a.

Cost of Debt net of Taxes

id*  =  id  (1  –  t)

b.

2.4%

Corporate tax

35%

Net cost of debt capital

1.56%

beta unlevered

0.159337

beta relevered

0.32116

β unlevered

 βu  =  β/  [1+(1  –  t)(D/E)]  

c.

cost of debt

β relevered

 β*  =  βu  [1+(1  –  t)(D/E)*]  

31

Cash Flow

WACC

TV

3

NFP, M, SA

WACC d.

Cost of Equity

ie  =  rf  +  β  (rm  –  rf)  

e.

risk free rate (rf)

1.25%

risk premium rate (rm)

7.75%

beta

0.962

final beta

0.32116

Cost of equity capital

3.34%

WACC

2.25%

WACC

iWACC  =  id*    x  (D/D+E)  +  ie  x  (E/D+E)  

32

Cash Flow

WACC

TV

3

NFP, M, SA

Terminal Value Computation of the terminal value (TV), using the following formula:

TVn=

CFn x (1 + g) (WACC – g) (1 +

WACC)n

=

9,297 x (1 + 0.25%) (2.25% – 0.25%) (1 +

2.25%)4

= 425,482.50

33

Cash Flow

WACC

TV

NFP, M, SA

3

Surplus Assets, Minorities, and NFP Expected Holding Period (n) g rate (g) Surplus Assets (SA) Minorities (M) Net Financial Position (NFP)

4 0.25% 12,000 10,000

(SA – M – NFP) = (12,000 – 0 – 10,000) = 2,000

34

3

Equity Value n

Equity = t=1

CFt + TVn + (SA – M – NFP) t (1 + WACC)

Equity = 10,245.54 + 425,482.50 + 2,000 = 437,728.04

35

Content 1. 

Company Valuation Fundamentals

2. 

Company Valuation Fundamentals: The Pillars of DCF

3. 

A Case of Company Valuation for PE Investment

4.  Applying Company Valuation to PE Settings 5. 

Applying Company Valuation to VC Settings: The VC Method

6. 

Launching Your Own Startup: Suggestions

7. 

PE and M&A – Interview with Eugenio Morpurgo

8. 

PE and IPO – Interview with Luca Peyrano

9. 

PE, Turnaround, and Restructuring – Interview with Raffaele Legnani

4

4

Introduction In PE deals as said in the previous clips, there is a double valuation issue regarding equity. As a matter of fact the PEI wants the equity value to be as low as possible in the beginning of the investment while the value has to be as large as possible by the end of the investment.

37

4

Inputs The exercise that follows is based on the assumption that the liquidity is not an issue for the exit from this investment. In this company, the business plan is solid and the assumptions are very reliable. Such is the case for investments made in expansion financing.

38

4

Inputs The issue can be addressed by following these steps: 1.  Calculating equity at time 0 2.  Calculating equity at time n In this case another business plan would be needed, which a PEI does not have in this case. So the next step is to calculate the IRR with the numbers available at the moment of valuation.

39

4

Inputs – Income Statement Inputs from the business plan

Expected EBITDA at exit

? 3

Expected holding period Expected NFP at exit Expected EBITDA multiple at exit PE Investment Post money share percentage

? 4 4,500 30%

40

4

Equity Value at the End of Investment Business Plan

Holding Period

Because the holding period is three years, exiting occurs in 2017.

 

2015

2016

2017

2018

2019

2020

Sales Operating costs EBITDA Depreciation EBIT Other income Interest expenses EBT

35,000 31,000 4,000 1,500 2,500 120 2,380

39,000 33,000 6,000 1,500 4,500 100 4,400

43,000 37,000 6,000 1,500 4,500 100 4,400

45,000 39,000 6,000 2,000 4,000 75 3,925

50,000 43,000 7,000 2,000 5,000 75 4,925

54,000 46,500 7,500 2,000 5,500 -  75 5,425

816

1,483

1,483

1,308

1,641

1,808

1,564

2,917

2,917

2,617

3,284

Taxes NET INCOME

-

-

 

3,617  

Net Financial position Increase net working capital Capex

4,500 1,000 5,000

4,000 1,000 1,000

4,000 1,200 1,000

3,500 1,200 5,000

3,500 1,200 1,000

 

3,000 1,200 1,000  

CASH FLOW (EBITDA – Taxes – NFP)

-6,316

-483

-483

-3,808

859

1,692 41

4

Equity Value at the End of Investment By using a multiple of 4 (as presented in the inputs table) we obtain the EV: 24,000 €/ 000. Because the equity value is only part of the enterprise value, we need to deduct the value of the NFP to get the equity value: Equity value (€/000) = 24,000 – 4,000 = 20,000 Given that the PE has the 30% of this equity, at the exit it represents 6,000 €/000 after having made an investment of 4,500 €/000 three years before. The IRR is 10.06%. It is good or bad? Nobody can tell except for the investors themselves. 42

4

Equity Value at the End of Investment For this reason, when the PEI undertakes an investment, running a sensitivity analysis is a common practice, by which the PEI combines on the one hand the EBITDA multiples and on the other hand it combines the holding period.

HOLDING PERIOD

EBITDA MULTIPLES  

3

4

5

6

7

8

1 2 3 4 5 6

-6.67% -3.39% -2.27% -1.71% -1.37% -1.14%

33.33% 15.47% 10.06% 7.46% 5.92% 4.91%

73.33% 31.66% 20.12% 14.74% 11.63% 9.60%

113.33% 46.06% 28.73% 20.86% 16.36% 13.46%

153.33% 59.16% 36.32% 26.16% 20.43% 16.76%

193.33% 71.27% 43.15% 30.87% 24.01% 19.64%

43

Content 1. 

Company Valuation Fundamentals

2. 

Company Valuation Fundamentals: The Pillars of DCF

3. 

A Case of Company Valuation for PE Investment

4. 

Applying Company Valuation to PE Settings

5

5.  Applying Company Valuation to VC Settings: The VC Method 6. 

Launching Your Own Startup: Suggestions

7. 

PE and M&A – Interview with Eugenio Morpurgo

8. 

PE and IPO – Interview with Luca Peyrano

9. 

PE, Turnaround, and Restructuring – Interview with Raffaele Legnani

5

Introduction The venture capital method (VCM) focuses on the relation among the expected IRR, the growth of the firm and the percentage of shares the PEI has to buy in order to become an active owner of the venture-backed company. This approach can be used (and it is typically used): •  For deals where the phase of price setting is fundamental •  For seed and startup deals in where it is difficult to determine the percentage of investment for the equity investor.

45

Step 1

Step 2

Step 3

Step 4

Step 5

5

The Venture Capital Method The venture capital method gives an answer to a very simple question: how many shares does a PEI have to buy considering the investment made and the expected IRR? This method develops over the following steps: Step 1: Step 2: Step 3: Step 4: Step 5:

The The The The The

future value of the investment TV calculation percentage of shares the PEI will own after the investment amount of share the VBC has to issue value of the newly issued shares

46

Step 1

Step 2

Step 3

Step 4

Step 5

5

Inputs Data Inputs

Value of the Investment Expected IRR Expected holding period Terminal year net income P/E comparable Ration Number of existing shares

4,500,000 45% 5 3,500,000 12 100,000,000

47

Step 1

Step 2

Step 3

Step 4

Step 5

5

Step 1: The Value of the Investment This activity concerns the calculation of the future value of the investment, considering the expected holding period and the expected IRR, where the expected IRR derives from the different constraints the investor has.

Future Value of the Investment = Value of the Investment x (1 + Exp IRR)n Future Value of the Investment = 4,500,000 x (1 + 45%)5 = 28,843,803.28

48

Step 1

Step 2

Step 3

Step 4

Step 5

5

Step 2: TV Calculation This activity concerns the setting of the expected holding period and the calculation of the terminal value. The P/E ratio can also be a starting point to calculate the TV, in addition to the DCF method seen in the previous clips.

TV = Value N Net Income x PE Ratio = 3,500,000 x 12 = 42,000,000

49

Step 1

Step 2

Step 3

Step 4

Step 5

5

Step 3: The Percentage of Shares After having computed the company TV, the investors need to compute the shares they have the right to obtain in return for the investment made.

% PE shares =

28,843,803.28 Future Value of the Investment = = 68.68% 42,000,000 TV

50

Step 1

Step 2

Step 3

Step 4

Step 5

5

Step 4: The Number of Shares to Be Issued This activity concerns the calculation of the number of new shares the venture backed company has to issue equaling to the percentage calculated in the previous step.

Number of shares =

Existing Shares x (% of shares) (1 - % shares)

Number of shares =

100,000,000 x 68.68% (1 – 68.68%)

= 219,214.20

51

Step 1

Step 2

Step 3

Step 4

5

Step 5

Step 2: The Value of Newly Issued Shares This activity concerns the calculation of the price of newly issued shares for the investor.

Price of new shares =

Value of the Investment Number of New Shares

=

4,500,000 219,214.20

= 20.53

52

Content 1. 

Company Valuation Fundamentals

2. 

Company Valuation Fundamentals: The Pillars of DCF

3. 

A Case of Company Valuation for PE Investment

4. 

Applying Company Valuation to PE Settings

5. 

Applying Company Valuation to VC Settings: The VC Method

6.  Launching Your Own Startup: Suggestions 7. 

PE and M&A – Interview with Eugenio Morpurgo

8. 

PE and IPO – Interview with Luca Peyrano

9. 

PE, Turnaround, and Restructuring – Interview with Raffaele Legnani

6

6

Introduction In this clip some hints and tips will be presented that startuppers should keep in mind before launching their own business. As a matter of fact, nowadays this is a very good moment to launch (well-built) start up in Europe too.

54

6

Favorable Conditions 1)  The first condition that may allow you to launch your own startup is the huge amount of liquidity available in Europe together with the fact that interest rates are lower à these conditions make an investor keen on investing in new projects. 2)  Nowadays there is a widespread interest in alternative investments which PE and VC belong to. 3)  On top of that, especially in Europe, there is a need for growth to enhance the GDP

55

6

Rules of a Well-Organized Sturtupper 1.  Commitment, hard work, and passion The fact that you, as the founder, believe in your work is a necessary element to convince external investors and to demonstrate to them that your company is a good investment. 2.  Right team In order to create a good company you need to hire the right people and the team should be made up of people as diverse as possible. 3.  Promotion of a glamorous idea. The investor has to fall in love with the idea at the basis of the company because the investors will trust a good idea provided that the founder believes in that idea too.

56

6

Rules of a Well-Organized Sturtupper 4.  Numbers, numbers, numbers!!! Passion is important as well as commitment. A startupper should never forget about the numbers: the VC looks for an IRR in the end. Once the idea of the founder is translated in numbers, the entrepreneur has to make sure that there is room for an (interesting) IRR. 5.  Be a risk lover The founders have to demonstrate to the investors that they are ready to face and share the risk with the venture capitalist. 6.  Be able to make other people commit VC will test the entrepreneur’s ability to convince other people, and this means that the start uppers have to be able to convince their own network.

57

6

Final Recommendations If you want to launch your own start up, remember that investors could be very different being: •  •  •  • 

Business angels High Net Worth Individuals Incubators Etc. ...

In any case, you have to remember that you have to select the most suitable one for your project and needs.

58

Content 1. 

Company Valuation Fundamentals

2. 

Company Valuation Fundamentals: The Pillars of DCF

3. 

A Case of Company Valuation for PE Investment

4. 

Applying Company Valuation to PE Settings

5. 

Applying Company Valuation to VC Settings: The VC Method

6. 

Launching Your Own Startup: Suggestions

7.  PE and M&A – Interview with Eugenio Morpurgo 8. 

PE and IPO – Interview with Luca Peyrano

9. 

PE, Turnaround, and Restructuring – Interview with Raffaele Legnani

7

7

Who Is Eugenio Morpurgo? Founder and CEO of Fineurop Soditic S.p.A. Long experience in the M&A world. Professor of Investment banking at Bocconi University.

7

Q&A What are the key trends in the M&A market today? “In 2014 we observed a positive trend of the M&A market, which continues through 2015, it is driven by acquisition financing and the liquidity availability of PE funds and corporations. Generally speaking, we can say we are very optimistic for the M&A market and we will for the next 6-7 months. As for the Italian market, it is dominated by foreign investors, both strategic investors and PE investors à “Quality assets” seem to be what the investors are more interested in. In addition, multiples speak for themselves, the EBITDA margin multiple was 9: a record over the last 15-20 years. I do not think that this is an Italian market bubble, again acquisition financing is very good and there is still room for mid-size acquisition financing projects, but this will depend on debt capital market, stock market and on the Grexit, which may affect these markets in the next 3-4 months (note: the interview was taken in early July 2015). As for the Italian domestic market, we still see a lack of strategic domestic investments, Italian investors are very cautious within Italian boundaries. This is a reason why PE is very important in Italy.”

7

Q&A PE is one of the main drivers of the M&A market. How do you see the relationship between PE and M&A today? “PE has a very important share in the worldwide M&A market, in Europe as well as in the US and this share is going to increase especially in those industries where corporate strategic barriers are low. I think that worldwide PE plays a very important role. As for Italy, this is even bigger for two reasons: in the first place the IPO market is very weak and PE could replace this IPO market, in addition to that PE can be extremely important to support domestic groups in consolidation processes.”

7

Q&A M&A is relevant and complex at the same time. In your opinion, what are the key issues for a company to manage M&A? “Looking at the buy-side, the due diligence has to be extremely accurate, especially when it comes to the value of the potential synergies and to what happens in the post-acquisition process. Looking at the sell-side, there are some opportunities in the IPO and M&A market and sometimes sellers concentrate on fundamentals and forget to take into consideration that the market can be very volatile. There is an M&A cycle, largely depending on the stock market and the liquidity availability. Therefore, sometimes the right window opens and closes very quickly. You should catch the right window!”

Content 1. 

Company Valuation Fundamentals

2. 

Company Valuation Fundamentals: The Pillars of DCF

3. 

A Case of Company Valuation for PE Investment

4. 

Applying Company Valuation to PE Settings

5. 

Applying Company Valuation to VC Settings: The VC Method

6. 

Launching Your Own Startup: Suggestions

7. 

PE and M&A – Interview with Eugenio Morpurgo

8.  PE and IPO – Interview with Luca Peyrano 9. 

PE, Turnaround, and Restructuring – Interview with Raffaele Legnani

8

8

Who Is Luca Peyrano? Head of Continental Europe for the London Stock Exchange. Long experience in managing IPOs. Great support to SMEs and bigger companies as they enter the financial markets.

8

Q&A An IPO is one of the exit mechanisms for private equity and venture capital. How do you see the relationship between PE and stock exchange and what are the key issues for an SME that jumps into the stock exchange? “PE is crucial to capital markets, also they are important to spread an equity culture. PE stands right before the IPO. There is now an always strong relationship between us and the PE community, not only on a local level. In the past, up to 40% of IPOs derived from PE. In these years, half of the capital raised from the London Stock Exchange comes from VBCs.”

8

Q&A What is Borsa Italiana (the Italian Stock Exchange) doing for SMEs and why SMEs are usually so reluctant to go public? “In Southern Europe there is a huge number of SMEs, not very close to the capital markets. It is mainly for them that PE plays a bigger role. The SMEs usually have a bigger perception of the distance between them and the stock exchange. This is more of a psychological problem rather than a technical one. Hence, we are creating markets that can be tailor-made for smaller companies, and we are trying to engage with companies at an earlystage of life. This is why three years ago we launched ELITE, which has proved to be very successful. It is not a market but a business support program for SMEs in which we train and coach companies and their managers.”

8

Q&A Can you say something more about ELITE that is becoming an exceptional format to sustain SMEs towards the capital market? What is the challenge for Borsa Italiana (Italian Stock Exchange)? “ELITE turned out to be a magical solution, not only for Italian SMEs. It is a quite recent understanding that let us know why companies would not go public. It is all about creating the right environment. We provide an early-stage training, together with top business schools, such as Bocconi University; then we move to a phase in which companies are pushed towards change. We ask them to explore new areas, such as business areas or their governance mode. Eventually we present them to our investors. This program does not necessarily lead to the stock exchange rather to consider all possible options that can accelerate growth.”

Content 1. 

Company Valuation Fundamentals

2. 

Company Valuation Fundamentals: The Pillars of DCF

3. 

A Case of Company Valuation for PE Investment

4. 

Applying Company Valuation to PE Settings

5. 

Applying Company Valuation to VC Settings: The VC Method

6. 

Launching Your Own Startup: Suggestions

7. 

PE and M&A – Interview with Eugenio Morpurgo

8. 

PE and IPO – Interview with Luca Peyrano

9.  PE, Turnaround, and Restructuring – Interview with Raffaele Legnani

9

9

Who Is Raffaele Legnani? Managing director at HIG capital. Long experience in restructuring and turnarounds.

9

Q&A Restructuring and "special situations" are part of the relevant business for private equity. How do you see today the relationship between PE and these areas? “PE can help companies throughout their life cycle. PE can turn ideas into businesses and can support expansion as well. PE funds can also help in their restructuring and turnaround phases. In today’s world, even if a company has a very sound business plan, it can be strongly hit by sudden events which change the value of the company. This is why PE funds that invest in change are more than welcome! Without such players in the markets these companies overwhelmed by change would go bankrupt and we would lose their so-called going concern value.”

9

Q&A What are the key issues for a PE investor that has to manage restructuring and special situations? “The most important thing is to have the right mindset. The PE has to look at all those unsuccessful cases and point out those few companies which have a chance. This is an important skill for a PE investing in turnaround and restructuring.”

9

Q&A In your experience and in your opinion, what are the key trends in the market for restructuring and special situations within the PE world? “In the last few years there is an increasing attention of banks towards distressed debt. For this, they created dedicated teams and they totally changed their attitude. Beforehand, they had a very passive attitude: they were more focused on legal technicalities. Now, they really want to understand the business and how they can create value in a company. This is a totally brand new mindset. On the other hand, banks are quite new to this approach and to this way of doing business. Therefore, I see a clear trend towards a partnership between banks and PE funds to work together and help distressed companies. PE can put in money and help banks in spotting the right companies in which to invest. This could help not only distressed companies but all of the economy after a domino effect.”