• 115 01/26/2021

    This post is Part 2 of an introduction to private equity. In this video we will explore how leverage can both create and destroy value. To highlight the benefits and dangers of excessive leverage two examples are included below in both video and text format. The first was a wild win for investors in the early 80s, and the second a modern-day private equity horror story.

    Leverage Creates Value: 200x Return on Capital

    The acquisition of Gibson Greeting Cards Inc. (Gibson) is one of the best examples of using leverage to make money in private equity. In 1982 a private equity firm purchased Gibson, which, and this may not be a surprise, published greeting cards. The firm paid $80 million, but borrowed $79 million to make the acquisition. The transaction closed with only $1 million of equity invested, $660,000 of which was split between two of the partners of the firm.
     
    The private equity firm took the company public in a stock offering that valued it at $290 million sixteen months later. The two partners realized a return of 200 times their invested capital, turning an initial investment of $330,000 into $65 million each. This transaction instantly became legend and is credited as one of the variables that convinced Steve Schwarzman to pursue a career in private equity. 
     
    It should be noted that this amount of leverage would be difficult to secure today, but it is a tremendous example of how returns can be enhanced when an investment performs. The counter is what happens when leverage is aggressively applied in the wrong scenario.

    (Click on the image for a larger view.)
     

    Best Private Equity Transaction

    Leverage Destroys Value: 0x Return on Capital
     
    Private equity funds typically apply leverage to each portfolio company individually to diversify away from the risk that any single loss will affect the rest of the portfolio. Unfortunately, EnerVest Ltd., a $2 billion private-equity fund, learned first-hand the risks of applying leverage to a levered portfolio of investments. The fund used $1.3 billion of debt across the fund (beyond the leverage used in the investments themselves) to increase the amount of capital it could deploy in energy investments.
     
    Unfortunately, the fund had two variables with the capacity to affect all of its investments simultaneously: (1) the aforementioned debt, and (2) the price of oil. When the price of oil started to plummet in 2014 the firm began to realize losses that ultimately could not be sustained. Per an article in The Wall Street Journal, it may be the largest private equity fund loss to date: "Though private-equity investments regularly flop, industry consultants and fund investors say this situation could mark the first time that a fund larger than $1 billion has lost essentially all of its value." 

    Introduction to Private Equity Series:

     

    private equity training

 



  • 114 01/26/2021

    Most concisely, private equity is the business of acquiring assets with a combination of debt and equity. It is sufficiently simple in theory to be frequently compared to the process of taking out a mortgage to buy a home, but intentionally obfuscated in practice to communicate a mastery of complex financial science. When encountered, the latter should be thought of largely as a marketing effort. Vocabulary aside, the process is simple. Incredibly detailed and at times chaotic, but not the product of financial wizardry. 

    The Private Equity Training course will focus on the acquisition of operating businesses with a history of positive cash flow using the aforementioned combination of debt and equity. In an effort to get readers up to speed expeditiously, in this video (Part 1 of 4) we will cover a few basic concepts, including:
    1. Private Equity Defined
    2. Comparison of an LBO Model to a Three-Statement Model (please see video)
    3. The Benefits of Leverage

    The Benefits of Leverage: Debt + Equity

    The benefits of leverage are easily captured by comparing identical investments that differ only in the amount of leverage employed. If the value of the asset grows over time, the amount of leverage used to acquire the asset will enhance the amount by which shareholder value grows. Think about the two terms as follows: 

    Debt is borrowed money that earns interest until it is repaid. There are two components to debt payments: interest and principal. Interest is the rate charged by the bank to loan capital to a borrower, and the rate is determined by the amount of risk assumed. Principal payments, which are defined by an amortization schedule, are payments made to reduce the balance of the loan. The final payment, known as the “balloon” payment, coincides with the maturity of the loan. For so long as the investment performs, and principal and interest payments remain current, the remaining principal balance for interest bearing debt will remain fixed.  (This definition combines a lot of vocabulary. Future lessons will break this down to make concepts easier to grasp.)

    Equity, on the other hand represents ownership. It is the value available to shareholder’s after all debts have been paid. It follows that as an asset increases in value, so does shareholder’s equity. 

    Per the table below, in both the Equity Investment Case and the Levered Investment Case, the shareholders own 100% of the same asset even though $100 and $25 of equity was used respectively to purchase it. In year one both investments grow in value by 5%, but a 5% increase on a $100 investment acquired with $75 dollars of debt causes the equity value to grow by 20%, which compares nicely to 5% growth in the unlevered example. 

    How Private Equity Works

    (Note: Excel workbook available for download.)

    Note that the Value Change and the Cumulative Value Change are identical in both scenarios. The only variable contributing to the different return profiles is the amount of debt used to acquire the asset, which brings me to my next point. In this course we are exploring the acquisition of businesses with a history of positive cash flow. This cash flow can be used to further reduce the debt burden by paying it down over the course of the investment, which reduces interest expense and lowers the risk profile of the business. The terrific artistic rendering below, where E.V. stands for enterprise value, further demonstrates how this also benefits equity value.

    How Private Equity Works

    As these simple explanations might suggest, the limiting factor for the private equity industry was not ingenuity. It was the availability of capital. Private equity gained popularity quickly as debt became increasingly available to finance what had previously been considered too risky. The amount of debt available to finance an acquisition has fluctuated over time. In the 80s, easy money, which refers to lax lending standards, made outsized returns easier to achieve for the small number of private equity firms looking to benefit from this growing alternative investment trend. To highlight the benefits and dangers of excessive leverage two examples are included below. The first was a wild win for investors in the early 80s, and the second a modern-day private equity horror story. 

     
    Introduction to Private Equity Series:

     

    private equity training

 



  • 113 01/12/2021

    In this post we will cover the M&A auction process from the buyside perspective by detailing a "standard" process for a private equity group. In any process the objective should be to win by the smallest margin possible. Every participant knows this in theory, but the gamesmanship and strategy involved in an M&A auction can make it difficult in practice (as the first video below will demonstrate). But before we dive into the strategy, let's first outline the process.

    The process is initiated by the investment banker. Per the image below, the investment banker will deliver a teaser to a list of all parties they believe might be interested in the opportunity. At this stage very little information is shared. If the teaser describes an investment opportunity that is even remotely interesting, the private equity firm is likely to execute the confidentiality agreement required to review more information.

    Once this document has been executed, the private equity firm will receive a confidential information memorandum. This document provides substantially greater detail, and if the contents confirm the private equity firm's interest, the next step is to start working towards the submission of an indication of interest (or first round bid if there is to be more than one bid). The image that follows organizes the timeline by the documents that are exchanged.

    M&A Auction Process

    In this process all potential buyers will be constantly evaluated by the investment banker and seller as they attempt to identify the most suitable buyer. All participants should keep this in mind at all times because this process can be stressful. Maintaining a cool, level-headed approach under any kind of emotional duress will reflect positively and it will potentially provide an advantage in the process.

    Unlike the purchase of public securities, acquiring an interest in a privately-held business is highly time consuming. Information is made available only to parties that demonstrate interest, and demonstrating interest requires due diligence. The more work that goes into any process, the greater the bias becomes to win the deal. A talented investment banker can and will use this to their advantage. This can be difficult to understand without an example, so we have included an anecdote describing precisely how this works in the video that follows.

     

    Being aware of the gamesmanship involved does not necessarily answer how best to engage in the process to avoid overbidding (to the degree possible). The ultimate objective in an auction is to work towards an understanding of what it takes to win the process. In an effort to uncover valuation in the current market, private equity firms will take the steps outlined in the video available below.

     

    The final video in this series addresses how private equity firms use the limited amount of information provided to bid. It also addresses how a private equity firm should respond if they arrive at the conclusion that the information provided is misleading.

     

    If the private equity firm's bid is accepted, they will be invited to submit a letter of intent (LOI). This is where scale starts to play more of a role in what is expected, largely because this entire timeline gets pulled forward as scale increases. In the lower-middle-market and core-middle-market of private equity much (definitions included below) due diligence will remain after the LOI has been submitted. On larger transactions there will generally be two rounds of bids before an LOI is submitted, with confirmatory due diligence taking place after the second bid. In the upper middle market and megafund category submitting the letter of intent is viewed as the end of due diligence. At this stage, the expectation is that all third-party work is complete, lenders are lined up and the investment committee has approved the transaction. In either case, and regardless of scale, executing the letter of intent brings the auction to a close. Then it is up to the private equity firm to close the transaction.

    Middle Market Private Equity

     

    This content is a highly summarized version of a more comprehensive lesson available as part of the Private Equity Training curriculum. Please click on the image below to learn more. 
     

    private equity training

 




 



Models are:
 
A) really boring
B) pretty sweet
C) super important
D) somewhat easy
E) kind of hard
F) fun
G) all of the above

 

 


*Answers a, b, c, d, e, f and g are all correct.