Session 7: PRIVATE EQUITY AND BUY-OUTS. Module: Mergers & Acqusitions and Private Equity

Transcription

1 Session 7: PRIVATE EQUITY AND BUY-OUTS Module: Mergers & Acqusitions and Private Equity

2 Session Recap 3 sources of law affect buyouts and mergers? What % ownership of shares in a listed company triggers a bid? What level of share ownership needs to be declared? What are the two aspects of competition law?

3 We are ever amazed at the wide range of issues that are covered in private equity. Nearly all business aspects are at the heart of the matter valuation, accounting and control, strategy, operations, financial structuring, asset allocation, management, entrepreneurship, regulation and government policy. Over the last 20 years or so private equity has grown to become a sizable asset class at its peak, responsible for up to a quarter of global M&A activity and as much as half of the leveraged loans issues in the capital markets.

4 Private Equity - Definitions Private Equity is equity capital invested by a third party manager in unlisted companies or to take listed companies private A Private Equity Fund is a fund set up for this purpose that may have some of the manager s capital in with the third party capital A Private Equity Firm is the manager/sponsor of a private equity fund

5 Private Equity Firms PE consists of VC and Buy-Out funds - Similar structure; different size and focus Mezzanine Funds Distressed Funds

6 Buy-Outs and Private Equity PE consists of VC and Buy-Out funds - Similar structure; different size and focus Leveraged Buy-Outs are normally funded by PE because the risk is too great for banks to accept Mismatch equity type risk and debt type returns

7 Private Equity American Research and Development, first formal PE firm, founded in 1946 by Karl Compton (left) President at MIT and Georges F Doriot (right) professor at Harvard Business School

8 American Research & Development Made high risk investments into emerging companies based on technology developed for WW2 50% of entire profits in 26 year history came from one deal: $70,000 investment in Digital Equipment Corp grew to $355 million Investors were individuals, institutions refused to invest Structured as a traded, closed ended fund (investment company) 1958 first VC limited partnership Draper, Gaither & Anderson 1960s-70s mainly closed ended funds or SBICs

9 Growth of Private Equity 1979 US Dept of Labor allowed pension funds to invest in high risk assets Limited partnerships became dominant structure 1980s funds backed technology successes: Cisco Microsoft Sun Microsystems Genentech And buyouts: Avis Beatrice Foods Dr Pepper

10 History of Buy-Outs First Leveraged Buy-Out that can be identified was in 1919 when Henry and Edsel Ford bought out the other shareholders of Ford Motor Co, the world s largest automobile company for $106 million, $75 million of which they borrowed from a group of East Coast banks

11 Ford 1919 Clash of Vision Henry Ford wanted the automobile to be affordable for the average American, which meant ever deceasing prices. The other shareholders, including the Dodge brothers, wanted to maximise profits

12 LBO History Ford deal an outlier; real LBO history starts from 1950s. McLean Industries Inc purchased Pan-Atlantic Steamship Co. in Jan 1955 and Waterman Steamship Co in May 1955 New trend for the 1960s, the use of publicly traded holding companies as investment vehicles Berkshire Hathaway (Warren Buffett) DWG Corp (Victor Posner)

13 1970s and 1980s 1960s bull market formation of conglomerates bear market DJIA fell from 1036 (1972) to 578 (1974) Privatisation and deconglomeration Sell off of divisions and subsidiaries Founding of LBO firms Kohlberg Kravis Roberts (1976) Thomas Lee Partners (1974) Forstmann Little (1978)

14 Buy- Outs April 12 (Reuters) - The following list ranks the largest leveraged buyouts since September, 2008, 1. IMS Health Inc Investor Group $5.08 billion 2. Busch Entertainment Corp Blackstone $2.70 billion 3. Tasc Inc TASC Inc SPV $1.65 billion 4. Styron Corp Bain Capital $1.63 billion 5. DynCorp International LLC Cerberus Capital $1.44 billion 6. SkyTerra Communications Inc SkyTerra Commun SPV $1.23 billion 7. RCN Corp ABRY Partners LLC $1.19 billion 8. Canadian Imperial Bk- Credit Cerberus Capital $1.05 billion 9. CKE Restaurants Inc Thomas H Lee $ million 10. Bway Holding Co Madison Dearborn $ million $ million SOURCE: Thomson Reuters

15 Takeover Bids 1 A takeover bid is an offer to buy a company outright. If a takeover bid has the the support of the directors of the company to be taken over (the target or offeree ) it is called an agreed takeover bid. If they oppose it is called a hostile takeover bid. Takeover bids are most commonly made by: other companies in the same industry private equity companies major shareholders or directors who wish to take a company private. Takeover bids usually create conflicts of interest between directors (who may lose their jobs) and shareholders (who are likely to be able to sell shares at above the market value before the bid was announced). Takeovers can also lead to situations in which minority shareholders can be unfairly treated.

16 Takeover Bids 2 Because of this, takeover bids are subject to regulation in most markets. The main British regulation is the City Code Code on Takeovers and Mergers. A key provision of the City Code is that (unless granted a waiver because of special circumstances) the buyer of a stake in a company that gives them effective control is obliged to make a mandatory offer to buy the rest of the shares.

17 City Code Mandatory offer The City Code (of the Takeover Panel) requires that if a shareholder or a concert party acquires more than 30% of a company it must offer to buy the remaining shares on terms as good as its most recent purchases. The reason for this is that 30%, although not giving a shareholder formal control, is sufficient to give effective control. When a change of control takes place it may adversely affect the share price. This is because minority shareholders are likely to worry that the company will be run to suit the controlling shareholder, and the interests of minorities may be affected. Therefore, it is only fair to allow them to sell out at the price that the new controlling shareholder paid before the change of control.

18 Types of PE Firm Independent 3 rd party Limited Partners provide most of the capital and General Partner is substantially owned by the management company Captive Parent or sponsor provides all the capital and management company normally a subsidiary of the parent Semi-captive Significant capital invested by sponsor, but additional capital taken from 3rd party investors. Management company may or may not be owned by sponsor. May be sponsored by a bank/financial institution or by industrial company

19 PE Firm Ranking Rank Firm Capital Raised Goldman Sachs Principal Investment Area New York 54,584 2 The Carlyle Group Washington DC 48,176 3 KKR New York 47,031 4 TPG Fort Worth, TX 45,052 5 Apollo Global Management New York 34,710 6 CVC Capital Partners London 34,175 7 The Blackstone Group New York 31,139 8 Bain Capital Boston 29,239 9 Warburg Pincus New York 23, Apax Partners London 21, Permira London 12, Terra Firma Capital Partners London 11, Bridgepoint London 11, Teachers Private Capital Toronto 10, AXA Private Equity Paris 9, Abraaj Capital Dubai 6, CDH Investments Beijing 4,100

20 KKR Jerry Kohlberg In late 1960s identified agency costs as a problem Had the idea to replace the diffused public shareholders with a small group of highly motivated investors In order to come up with the money to buy out the public, the small group would borrow heavily usually pledging the assets of the company

21 Henry Kravis and George Roberts Henry Kravis and George Roberts, First cousins, families very close Adopted by Jerry K at Bear Stearns Two bright, hard working young men JK put up $100K for 40%; giving HKand GR 30% each for $10K. HK/GR both hesitated for months before agreeing!

22 KKR Modus Operandi 1 Trick was to find suitable companies Solid companies Dedicated managers Industries not subject to sudden technological change With room for improvement Two types of candidate Family companies with succession issues Divisions of multinational companies No hostile deals

23 KKR Modus Operandi 2 Detailed analysis Cashflow Expense management Competitive position Productive efficiency Management quality, experience and attitude Arrange financing Gearing up from 2x to 8 or 9x

24 Up, Down, Up, Down and Up Again? Up in the early/mid 1980s: profits attracting new entrants Decline in the late 1980s and early 1990s owing to over-investment in a few sectors and over competition Up in mid/late 1990s, exit of previous newcomers with burnt fingers lowered competition; healthy IPO market made good exits + rise of dot. com companies Early 2000s dot.com crash followed by rapid rise in mid 2000s until Lehman when everything stopped wandering in the wilderness

25 Up, Down, Up, Down and Up Again? wandering in the wilderness Debt scarce and expensive Buy-Outs using less debt Size of Buy-Outs decreasing BO firms adjusting their focus Decreased fund raising.

26 Limited Partnership Structure

27 Limited Partnerships societates publicanorum, 3rd century BC Rome Qirad and Mudaraba, medieval Islam Commenda, 10th century Italy Colbert s Ordinance, France 1673 Limited Partnership Act 1907 The main UK law in force today One (or more) general partners with management control, share the right to use partnership property, share the profits of the firm in predefined proportions, and have joint and several liability for the debts of the partnership Limited partners have limited liability, only liable on debts incurred by the firm to the extent of their registered investment and have no management authority

28 Limited Partnerships Legal status varies according to jurisdiction In England, do not have legal personality In Scotland do have personality Governed by a relatively light statutory and regulatory regime compared to companies and other fund vehicles. Will be a collective investment scheme under FSMA If manager or GP in UK, must be an FSA authorised person They are governed by the same law as general partnerships (under the Partnership Act 1890, unless conflicting with the 1907 Act)

29 Limited Partnerships Tax transparent (pass through) The LP itself is not taxed and the partners are taxed as individuals on their share of the partnership income, whether dividend, interest or proceeds of sale An increase in the value of an asset is not a chargeable event for capital gains tax LP must invest, not trade, in the UK Partners contributions normally structured as 99% loan and 1% equity (partnership capital) Enables the LP to dispose of investments and return capital to partners as repayment of loan

30 Limited Partnerships Carry LP In return for sponsoring and managing the fund, and to incentivise those individuals managing the fund s assets, the founder partners typically receive a carried interest in the fund The most common structure in UK funds is for the carried interest partner to be a special limited partnership, which is itself a limited partner in the English LP It is heavily subordinated, being lower down the waterfall of interests paid out of the limited partnership returns. It is, therefore, usually bought for a nominal amount.

31 Limited Partnerships Carry LP waterfall Management fee (or priority profit share). This is paid to the general partner or manager. Investors contributions. This comprises capital and loans advanced by the investor limited partners to the partnership. The preferred return (or hurdle). This is usually expressed as a notional rate of return on the amounts of the investors contributions, which the fund must outperform before any profits are to be paid to the carried interest partners. Further profits. These are split between the investors and the carried interest partners in whatever ratio has been agreed in the partnership agreement. An 80:20 ratio is typical. However, there is often a catch-up stage in calculating the distribution of investment returns so that the carried interest partners share in those returns made after returning contributions to investors, rather than simply profits over and above the preferred return.

32 Why is Private Equity Necessary? Financing young / restructuring businesses is high risk Agency costs make debt and equity difficult to raise Information asymmetry (lemons problem) make outside capital more expensive to raise PE solves all these problems: Screening of investments Use of convertible securities Syndication and staging of investments Oversight, monitoring and informal coaching No other institutions can do this Lack expertise, poor reward structures and risk/return ratio

33 Private Equity Firms Small compared to investment banks Highly flexible Quick reacting Transparent, each partner can be observed, monitored and rewarded Funds self-liquidating Self discipline (euthanasia for the zombies) Danger of grand standing Specialised PE partners help investors take necessary leap of faith Returns from good active management highest in inefficient markets

34 Fees and Investment Factors Value added approach vs. financial engineering Can the PE firm build a better business? Opportunities for contrarian investment strategy Distinction between VC and buyouts became blurred in 1990s LP Fees 1.5-3% p.a. of i) funds invested; ii) assets Carried Interest 80:20 split usually above a hurdle rate Hurdle rate depends on sector Carry payment may be subject to management fee recovery

35 Sponsor contribution and drawdown Normal contribution to fund by GP is 1% but can be more or less Drawdown/takedown schedule used to avoid depressing returns Provisions for delinquent LPs No liquidity for LPs, though GP may assist transfer if required No termination for LPs unless major default by GP

36 Manager Restrictions Limit on max investment in a single company or in 2-3 largest holdings Limit on leveraging the fund Limit on co-investment with earlier funds from sponsor Limit of reinvestment of profits Restriction on GP investing directly in firms Restriction on sale of GP s participations Restriction on future fund-raising Restriction on GP staff s outside work Restriction on addition of new partners

37 Investment Restrictions Limit on holdings of an asset class, eg public securities or combination of two asset classes Limit on types of investment eg LBOs or Limit on investment sectors

38 Private Equity Funds of Funds Many of the best funds restricted who could invest in order to prevent too rapid growth and organisational disruption Often limited to existing investors As popularity of PE grew, both individuals and institutions new to PE invested through fund of funds, a fund that aggregates funds from a number of limited partners FoFs normally focus on primary funds but there are some secondary funds and some do co-invest directly alongside the PE fund Fee 1% + possible carry (double fee load for investors)

39 Intermediaries Investment Advisors or Gatekeepers Around since 1972 Advisory service to some clients and discretionary service to others Consulting firms eg Cambridge Associates Monitor performance, advise and recommend Placement Agents 0.5% - 3% + some of the carry Often require upfront payment

40 E M Warburg, Pincus Eric Warburg (left), cousin of Sir Siegmund (centre), battled over the use of the family name in New York, where Eric had the PE firm. Siegmund disliked Lionel Pincus (right) the wrong kind of Jew, whom he thought of as rag trade more than high class banking

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