L_2. The Fundamentals of Private Equity and Venture Capital

Summary .......................................................................................................................................... 2 
1.  PRELIMINARY DEFINITIONS....................................................................................................... 4 
1.1 The Consequences of the Financing .......................................................................................... 4 
1.2 The Taxonomy of PE Clusters ..................................................................................................... 5 
2.  PRIVATE EQUITY INVESTORS: TWO DIFFERENT FORMATS ....................................................... 8 
2.1 Closed‐end funds in Europe ....................................................................................................... 8 
2.1.1 Lifetime of a Closed End ........................................................................................................ 10 
2.2 Limited Partnership in the Anglo‐Saxon format ...................................................................... 11 
3. THE ECONOMIC MECHANISM OF AN AMC ................................................................................ 13 
3.2 Management Fees ................................................................................................................... 13 
3.3 Carried Interest ........................................................................................................................ 13 
4. PRIVATE EQUITY TRENDS 2012– 2018 ....................................................................................... 15 
4.1 European Private Equity........................................................................................................... 15 
4.2 Global Private Equity: Lead Players ......................................................................................... 15 
Conclusions .................................................................................................................................... 18 
 

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Summary

When it comes to analyze private equity funds, it is important to distinguish between two different
legal frameworks, the European Union Format and the Anglo-Saxon format. In the EU, private
equity is considered a financial service and it is therefore supervised by financial authorities. This
leads to a higher protection for the investor but also to higher costs and lower flexibility for funds.
In the Anglo-Saxon world, private equity is considered as an entrepreneurial activity rather than a
financial service. The difference between the two formats impacts on the fundraising activity of the
private equity firm and on the relationship between the sponsor group and the investors.
As stated above, in the European Union the regulation of private equity activity is not centralized at
European level, but each Member State has its own rules. However, the laws of each Member State
have to be in line with the guidelines of the Banking Directive and the Financial Services Directive.
Within the EU Framework, three key market players can be individuated.
Firstly, there are Banks. In the EU, the banking system is based on the model of the Universal
Bank, which can provide any kind of financial service.
Secondly, there are Investment Firms. They are defined as “any legal person whose regular
occupation or business is the provision of one or more investment services to third parties and/or
the performance of one or more investment activities on a professional basis” (Directive
2014/65/EU of the European Parliament). Investment firms cannot develop banking activity but can
manage equity investments, lending activities and payment services.
In the end, there are Closed-End Funds. The closed-end fund is promoted and managed by an
Asset Management Company (AMC) and the financial resources of investors are invested into a
closed-end fund. While the AMC is a financial institution, the closed-end fund is a separate legal
entity that invests money for a pool of investors. The closed-end fund is non-floating and therefore
investors are able to invest only during the fundraising phase and they exit only at the end of the
life-cycle of the fund. This is the most used format of private equity fund in Europe (Caselli, 2010).
Banks and Investment Firms are regulated by the Banking Directive; Closed-End Funds are
regulated by the Financial Services Directive and the Alternative Investment Fund Managers
Directive.
In the Anglo-Saxon world, private equity is seen at an entrepreneurial level as an activity that is not
considered as part of the financial system environment. Most Private Equity funds are organized as
Limited Liability Partnership (LLP) sponsored by private equity firms. The latter are usually small
organizations owned by few investment professionals. They serve as general partners (GPs) for the
private equity fund (Iannotta, 2015). It is important to remark the clear difference between GPs and
Limited Partners (LPs).
General Partners are the investment professionals who own the private equity firm. They have
managerial power over the private equity funds and they are fully liable .

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Limited Partners are investors who provide the majority of the fund’s capital. They benefit from
limited liability and are therefore exposed only for the amount of their invested capital but do not
have managerial power over the fund.
The association contract that specifies the terms of the LPs’ investment into the fund is called
Limited Partnership Agreement (LPA). By signing the contract, the LPs promise to provide a given
amount of capital which takes the name of committed capital. Once the committed capital has been
raised, the fund is closed and the screening and investment activity of the GPs begins.
The nature of the private equity business is to invest the raised capital in target not listed companies
and obtain a return on their investment by selling their portfolio companies after having increased
their equity value. Thus, private equity investments are characterized by a precise schedule and its
process can be divided into four phases:

 Fundraising. This activity is performed by GPs or the AMC to collect the commitment
from investors to provide financial resources to the limited partnership/to the fund that will
be invested. When all the committed funds have been collected, the investment vehicle is
created.
 Investing activity. The GPs or the AMC invest the resources they have collected to acquire
equity stakes into potentially high-growing companies and creating value. The Target
companies are selected after a process of market scouting, screening and negotiation.
 Managing & Monitoring. To create value, the investment professionals actively influence
the business activity of its portfolio companies.
 Exiting. The private equity fund will be able to remunerate its investors by selling
ownership stakes in the portfolio companies. The most common exit strategies are the trade
sale to a strategic buyer, the IPO, and the sale to another private equity.

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1. PRELIMINARY DEFINITIONS

The definition of Private Equity (PE) is based on two aspects, each related to the two main
characteristics of the PE relation. On one side, 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. On the other syde 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). In
Private Equity we have to distinguish between Venture Capital and Buy-out investments. Venture
Capital is a very specific case of PE and it is the investment realized by a private equity investor at
the beginning of the life of a company, at the start-up period. Buy-out: investment of PEI placed in
a company in its later stages, when the company is mature. Both transactions are part of the private
equity world.
How does the relationship between the PEI and the venture backed company (i.e. the company
financed by the PEI) work? On the one side, in order to raise funds, the company (venture-backed
company) is willing to sell a piece of its equity that is not listed; while on the other side there is a
private equity investor willing to buy this equity non-listed. Thus, the investor gets shares of the
equity of the company in return for the inflow of cash.

This transaction is explained from two perspectives that are:

 Governance: a company that decides to finance itself by selling equity that is not listed
must accept a PEI, qualified investor, in its governance, that might interfere with its
decisions. It is therefore a kind of marriage: accept to share governance.
 Return: the return that PEI expect is not dividends but only the appreciation of the equity:
capital gain return. Therefore, it is a marriage with an end, usually lasts 10 years.

In Private Equity there is 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 PEI will not only
become a shareholder but will contribute to the management of the company. The professional
investor will create profit only through the generation of capital gain. The most critical aspect in PE
is the strict relationship between the investor and the entrepreneur.

1.1 The Consequences of the Financing

 
Three perspectives that PEI take into account when investing in private equity (that makes it special
and different from public equity). These perspectives explain why you need qualified investors,
because you have to deal with these three risks:
Pricing: the company is not listed in the Stock Exchange Market, so there is no a published price to
refer to. Therefore, you start a negotiation process with the counterparty. You start by identifying
the value of the company (equity). You then pass from this intrinsic valuation to the price that could

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be acceptable for the counterparty [long process]. If you are not a qualified investor it is difficult to
find the right price to sell the equity at.
Liquidity: there is no a market to refer to and so to resell your investment. Your possibility is either
another private equity investor, but it is tough because the acquirer would be expert like you so it
would be difficult to negotiate and long and expensive. There is therefore a liquidity issue. Another
possibility for you could be selling to a financial or strategic investor or you can go for an IPO (but
this means at least 6 months).
Monitoring: in public, there are always supervisors and authorities to protect shareholders, but when
private there are no: you have to protect yourself.

To properly understand private equity, we also have to understand why companies (besides PEI)
accept a deal like this. Before we were analyzing from an investing perspective, now financing:

 Financial benefits (increase equity, increase rating, decrease cost of capital, increase debt
capacity);
 Certification benefit: need the name and certificates, need to prove to the market through the
investment that the service/product is a good one.
 Knowledge benefits: you need the investment of a qualified investor that has soft skills or
hard skills necessary to properly manage the activity and the company.
 Networking benefits: there are periods in the life of the company when you need to meet
potential new customers, suppliers, lenders.
 
Minority investments are done at the beginning of the life of the company. Majority investments at
the mature stages. In both cases, you have to interact with the governance.
Certain types of private investors are purely financial investors (Hands-off): do not participate in
the management. However, most investors have a hands-on approach, which means they do not
only provide funds but are also interested in the management.
 
1.2 The Taxonomy of PE Clusters

The life cycle of the company is important in order to understand if a company can use PE to
accomplish its needs and also to identify the different kinds of PE investment (and the right one).
As said, 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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There are six different types of investments relative to the stage of life of the company. The six life
stages each related to the suitable private equity investment are as follows:
 
 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.
 STARTUP
This is when the business actually starts. For this phase, the PE investment is called startup
financing. Investment in fixed assets and working capital.
 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 first three stages constitute the venture capital business.

 
 EXPANSION
In this phase, the sales keep on growing at a very high rate. The corresponding investment of
the PE is called expansion financing. The product created and proposed to the market is
successful and we have to support the expansion of the business and we now need additional
funds.
 MATURE AGE
This is the moment when sales growth is stable. The PE investment is called replacement.
Help to finance the acquisition of new companies: in this stage the firm wants to change
something.
 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.
 

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These last three stages constitute the buy-out business.

In each stage, there is a different market and a different risk return profile.
The riskiest stage is the first one because there is no history of the company and there are no
collaterals. This stage is when the idea is supported by the funds of the entrepreneurs and the funds
of the private equity investors, willing to support the risk even if the company does not yet exist.
Another risky stage is vulture financing, because we have to be ready to support the risk of not
having the insurance, guarantee that the company will be rescued. So, there is the risk of not being
able to recover from the company’s itself investment.
 

 
Acquisition of Valentino Fashion Group by Permira Investment Firm (2007)

Most iconic deal done in Italy. Very complex. Valentino was a phenomenal brand (very difficult to build a brand, emotional effort) but it had aged
a bit. In 2007, customers were mostly >47 years old. That was a bit worrying but also an opportunity. They did a huge transformation and put
the brand back in touch with the customers.
How did you replace Valentino “the man”?
They found the right people for 2 reasons:
They had a fundamentally beautiful brand and they believed in it
In 2007, they hired a new designer (a wrong guy) + crisis  they only succeeded because eventually they found the right people, Mr. Chiuri
and Mr. Piccioli, who had always been with Valentino. One of them has now become the chief designer of Dior.
They took a good band, redesigned it and resold it to the Royal family of Qatar for $1bn. They put oil into this machine and is now worth $3bn
 

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2. PRIVATE EQUITY INVESTORS: TWO DIFFERENT FORMATS

Regardless where the deal occurs, there are two legal frameworks, each having its regulation and
players:

 The European Union format regulated by a Directive of the European Union;

 The Anglo Saxon format 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, Russia and others; whereas the
Anglo Saxon format is also used in India and Australia.
 
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 European 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.
In Europe, private equity firms are meant as financial services/institutions. You have to follow a set
of rules to guarantee that your business is organized with efficiency and stability. So, when you want
to start your business in Europe, you need to ask authorization to the local central bank and accept
supervision of local supervisors.
The three legal entities that can ask permission to start their own activity to the local supervisor are
Banks, Investment firms and Closed-end funds.

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 laws, ad hoc fiscal rules and special regulations
for the PE world. In the end, in the Anglo Saxon format, there is no authorization/supervision. We
can start the business as long as it is not against the law. There are different ways to organize the
business. The most usual are Venture Capital Funds (most important), Small Business Investment
Companies, Corporate Ventures, Banks, Business Angels.
 
2.1 Closed-end funds in Europe

As anticipated, 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:

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In this part, the attention is focused on closed end funds.
 
Closed‐end funds 

 
 
An investment made through closed end funds consider a two level system involving two
different institutions:

 The AMC (Asset Management Companies) is a financial institution that 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.
 
When referring to closed-end funds, there are three players to consider:

 AMC
 Closed-End funs
 Investors

Instead, when you organize your business as a venture capital fund, the main players are:

 General Partners
 Limited Partnership
 Limited Partners
 
Asset management company (AMC) is the one that manages the company’s funds; while general
partners manages limited partnership, using the money of limited partners (while with closed-end
fund, the money used is that of investors). The AMC is a consulting company that decides to enter the
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private equity business and the first thing that has to do is asking the authorization to the local bank.
Shareholders of AMC can be States, Banks and Private individuals, with certain characteristics.
Legislators to shareholders of these AMC also request shareholders to be ready to invest, into the consulting
company, at least the 2% of the total funds that they are going to raise from investors. The Fund is like a
bank account where you collect all the money of investors. Characteristics: in the financial directive, we read
that a fund can be organized as an open-end and a closed-end fund: open-end means that you can enter
whenever you want in the fund (not necessarily at the beginning) and you can exit the fund also before
maturity. So, you have flexibility. In a closed-end fund, you enter (as investor) at the very beginning, when it
is launched in the market (during the fund-raising period) and you exit at maturity. However, you can exit
the fund when finding someone who replaces you (in the secondary market), while in an open-end fund the
manager of the fund has to be ready to liquidate investors before maturity if they request so. This because
you don’t want pressure in terms of liquidity from investors. The Investors have to be ready to accept
long-term investments and have to trust completely their AMC. Investors are usually very wealth
private individuals, but also pension funds, insurance companies and banks can be investors. Less
engaged alternative of the three is represented by banks because they spend money in terms of regulatory
capital by investing in such risky activity. Private equity is the riskiest business that you can enter as a bank.
In VCF, general partners manages the limited partnership (vehicle) to decide how to use the money
collected from limited partners. Limited partners are limited because the maximum amount of funds
they risk is the funds they invest. General partners instead can risk more than what they injected.
The first difference with respect to the European framework (Closed-end fund) is that general
partners have to be ready to invest at least the 1% of the funds collected. Another difference is that
in Europe the fund cannot leverage its own position. In US (VCF), instead, the limited partnership
has the possibility to leverage its own position.
In Europe the relation between AMC and Investors is regulated by the so-called “Internal code of
activity”; in US there is a “limited partnership agreement”. Difference: both are contracts in
which you agree how to manage the fund/limited partnership and the economic mechanisms, but
limited partnership agreement is a private agreement, while for the internal code of activity you
need the approval of the local central bank.
In these two contracts (equal from a legal point of view), there are the same economic mechanisms
meant as remuneration for AMC and called “management fee”: fixed percentage paid on yearly
basis addressed on the so-called “committed capital”: capital committed by investors. (The fee is
usually 2% of committed capital).
 
Example: C.C.=$100 m; MF=2%/yearly  $20 m; maturity=10 years.
At time 0, your break even (to pay back your investors) = 20/80=25%.
To the management of the vehicle you also pay a carried interest: paid on the capability to perform well, in order to incentive the performance.
It is expressed as a percentage of the IRR (usually 25%-35%).
 
2.1.1 Lifetime of a Closed End

In the life time of a Closed End Fund the following moments are the most important:

 Time0
 Time3
 Time N – 0.5 (where N is the end of the fund)
 Time N + 3

 
 
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First of all there is 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.
 
Commitment: is NOT investment, but money that investors promised to put in investments (PE vehicle), it is a preliminary phase (when the
opportunity comes out, the investor will be made)
 
 
In the second stage we have 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.

In the third stage, there is the 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:

 Year 0 3: first investment

 Year 3 5: exit from the first investment
 Year 5 7: second investment
 Year 7 10: exit from the second investment
 
Finally there is eventually the Extra Time (the grace period). 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.

2.2 Limited Partnership in the Anglo-Saxon format

 
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.

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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
 
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 have to pay taxes.
 
 

 
 

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3. 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). What about the 
managers of the funds? The goal of this part is to understand how the AMC is remunerated over the fund’s 
lifetime. Over the life of the investment, the AMC receives two different kinds of remunerations, 
management fees and carried interest. Please note that the rules that will be presented are also valid for 
fund managers operating in the US as long as they operate in PE deals. 
 
3.2 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 fee 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.
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. 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 venture backed
company.

3.3 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 is a discount rate that equals the investments with the present values of the future returns of
such investments. 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.

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 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.

Simple carried interest:

Committed capital = €100 mln
Total exit value = €200 mln
Simple carried interest in place = 20% (applied to the positive internal rate of return of the vehicle)
Carried interest = (200 - 100)*20% = 20 million
There are certain rules that can be applied and engaged in PE investments; one of these is the Hurdle Rate.

Carried interest with the Hurdle rate:

The hurdle rate is a threshold rate, a preferred return we want to pay to investors even before we pay the carried interest to GPs/asset mngt
company.
Committed capital = €100 mln
Total exit value = €120 mln
Carried interest = 20%
Hurdle rate in place = 8%
The hurdle rate is 8% of the committed capital = 8%*(100) = €8 mln. Before paying a carried interest to the GPs/managers, we want to pay a
preferred return to the investors, addressed on the committed capital.
The carried interest is going to be paid on what remains.
Therefore, the carried interest is = (120 - 100 - 8) * 20% = €2.4 mln.

Carried interest with the Catchup clause:

Once hurdle rate is paid to investors, we can anticipate the payment of carried interest to managers and general partners.

Committed capital = €100 mln

Hurdle rate in place = 8%
Carried interest = 20% on the IRR produced by the bank hold
Catchup in place (it's a provision, a clause agreed upon with investors)
Multiple investments with different times of liquidation:
Time 1: liquidation of €109 mln
Time 2: €1 mln
Time 3: €10 mln
Total = €120 mln
We are just changing the time when we are going to pay the carried interest:
Time = 1: liquidate investment of 109 million; capital gain of 9 -> year 1 we have 109 million at our disposal and we pay 8 million to our
investors (we are paying the hurdle rate = 8%*100); (109-100)*20% = 1,8 million (does not consider the 8 million for the hurdle rate; 1.8
is addressed directly to the committed capital-consider simple carried interest). We have 1 million at our disposal so you start paying just
that 1 million.
Time = 2: liquidate 1 million. Total cumulative proceeds = 110 million. Capital gain is 10 million. General partners should receive (110-
100)=(10 million)*20%= 2 million. We have already paid one million to them so at the end we should pay 2 million - 1 million (anticipated
in year 1).
Time = 3: liquidate 10 million. Total cumulative proceeds are 120 million; total capital gain = 20 million. (20 million*20%) = 4 million - 2
million (paid in the previous years) = 2 million.

The difference with the simple carried interest is that here you can pay during the life of the fund/limited partnership, instead of doing the whole
calculation at the very end.

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4. PRIVATE EQUITY TRENDS 2012– 2018

4.1 European Private Equity

The European private equity (PE) market as a whole (buyouts and exits) showed, yet again, a
marked improvement in 2017 on both a volume and value basis. Volume increased by 6.9% to
2,183 transactions and value was up 14.4% to €250.1bn. This means that European PE activity has
reached a post crisis high on both fronts, with all asset classes being sought after and showing a
further growth after a very strong 2016. The European deals market has as such grown impressively
by a CAGR of 9.2% since 2012, despite geopolitical uncertainty and tremors, as well as market
volatility and low growth macroeconomic conditions.

 
 
4.2 Global Private Equity: Lead Players

First 10 investors in terms of capital raised, excluding GS, are: Carlyle, Blackstone, KKR, GS,
Ardian. They have a lot of dry powder available. They are typical LBO funds. This is the biggest
share of the PE market.

 
 
 
 

 
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If we do study the market of PE investments the trend of commitment in Global PE partnerships

/vehicles we do get that partnerships are one of the main PE vehicles we have active in the market.
North America vs. Europe in the period from 2000 (tech bubble – venture capital very active) to 3Q
2017 tells as that the most important market for commitments in terms of quantity is the US. Trends
(in terms of quantity of commitments flowing in PE) is cyclical: peak in terms of flow right before
the burst of thee financial crisis (2000-2003 for tech bubble, 2007-2008 for financial crisis). In
terms of size, in EU and US, the market for PE commitments has rebounded the pre-crisis period.
Currently there are inflows in PE investments because investors look for something that gives
returns (as IR are low), as PE investments.

 
 
When you do an M&A, you can buy-out another company. Buyers may be strategic (competitor) or
financial buyer. This graph is pointing at the quantity of acquisitions carried out by non-industrial
buyers (PE investors). These are investments, not commitments. Bars: global volume of all M&As,
including strategic and non-strategic buyers. Continuous line: % of these deals represented by non-
strategic buyers out of total volume. The 2005-2016 trend is very similar to the one in the previous
graph. Why? When you have lots of money flowing to PE investments, as a consequence you have
lots of money to spend to buyout companies  you can expect to have a more important role of
financial buyers. Strategic buyer pays price depending on synergies he can get when buying the
company. A financial buyer pays a price determined by multiple and leverage. If you have lots of
money and the market is cheap in terms of COD, a financial buyer pays more than the strategic
buyer (paradox).
 
Suppose you can raise 10m equity. At the same time, you can raise 60m debt at cheap cost. If you put together 70m, you can buy a company.
A strategic buyer is unlikely to push the leverage so high (risk to go bankrupt)  he’s more conservative than PE investor. When debt is cheap,
the is more temptation by non-strategic buyers to raise leverage  risk that companies have too high leverage

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Looking at the chart of US PE by sector, we divide by segments that make up commitments.

Buyout is the most represented segment throughout the years: in the lifecycle the business is mainly
made of buyouts, the remaining part being only a tiny fraction. Investors are typically investors in
LBOs. The same holds for Europe as well: the most important components of PE market are LBOs
(from a financial point of view).
 
Technical words:
Commitment: money promised to be invested in PE vehicle
Investment: money invested
Dry-powder: powder that you have available and have not yet spent. PE investors already gathered the cash to make the investment but didn’t
spend the money yet.
Currently, lots of money are flowing to PE investments  when you have more money, temptation to invest is stronger  but available cash to
make new investments is growing. It must mean there are not many investment opportunities
Risk of PE investors to be forced to invest because the turning point of the cycle is arriving. At a certain point I will have to invest and, if there is
lots of pressure because dry powder has increased (i.e. dry powder + cheap debt around): risk that I buy firms paying them too much 
temptation to overpay  this marks the peak of a cycle  this might be the sign of a bubble and of a correction of prices approaching
(potential bubble)
 
   

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Conclusions

Private Equity is a business with a broad definition. It is useful to remind the definition given by the
SEC: “Whatever investment in equity instruments with an active approach by the investor and
with a definite exit strategy”. Equity instruments: common stocks + preferred stocks + quasi-
equity instruments. We can have an active approach buying stocks and intervene in the activity of
the firm. It can be very intense, e.g. if you buy the majority of the shares of the firm. In any case,
you have a clear say on the strategies of the company. Investors can be divided into 2 main
categories: hands on and hands off. Hands-off approach: strategy of PE investor with financial
background. I will never challenge the choices of management firm but I will intervene in the
activities having a close eye on the financial performance. Hands-on approach: PE investors with
industrial background. Typical of very first phases of lifecycle of the firm, where investors provide
money but also skills, capabilities, network etc. to shape the future of the company. They make
strategic decisions and they can do it only because they know the business. At a given point, you
will want to leave the investment. You can do it in many ways:

 Strategy 1: IPO – You can sell the shares in ECM (most common way)
 Strategy 2: Trade Sale – bilateral and private transaction (the company remains private) to:
A strategic/industrial buyer (competitor, supplier, customer)
Another PE that wants to takeover your firm
 No exit: Write-off – your firm goes bankrupt.

Example: Suppose you are an investment vehicle and 5y ago you invested in a firm. The firm has not performed and the value of the stock is
close to zero or the company has defaulted (so that the value of equity is almost 0). At a certain point, since you cannot sell a bankrupt
company, unless there is still a minor possibility to rescue it, you can only write-off this investment and exit the investment. Is a forced exit.
 
Depending on the kind of equity we invest in, we can operate in different businesses. According to
the firm life cycle, the strategies of PE can be very different. We can be investing in the same
instrument (equity or semi-equity) but the kind of company we are investing in is very different. In
the early stage investments (venture capital) with a very new businesses to enter in. Often not yet
producing earnings. Entrepreneur needs money and also needs competences. Riskiest form of equity
investment because there is high uncertainty. Hands-on approach here is fundamental to understand
your investment. If the company is sufficiently credible, it goes through: During the expansion and
late stage investing in private firms with a good market potential and management team, with
consolidated business model and available prototypes. The PE investor injects capital in the
company to allow it to invest more in the business and grow. With a replacement of capital & LBOs
there is a venture backed company that is mature and the PE doesn’t provide a capital increase, no
need for it. PE just replaces current shareholders with new ones (the PE investors). During
expansion, you launched a capital increase and the PE injects extra money BUT HERE the money
flow from the buying to selling shareholders. Company doesn’t get any money. Distressed Investing
or Special Situations investing in companies not doing well paying a very low price (because I want
to restructure or do speculative trading).
 
According to the stage of the investment, you have very different investors.
In the early stage you have Sequoia (incubated successful companies but also Netscape – that failed poorly – so this means there is 50-50
probability of having the good firm)
Later stages: Apollo etc.
Apax, Blackstone etc. are the mega funds
 
For what regards the legal structure of the vehicle changes if you are under the common or civil law
countries where the jurisdiction changes. In both cases, we are considering an investment where the
level of liquidity is zero (i.e. private firms or public firm that are delisted): illiquid investment is
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typically addressed to LT investors. Limited partnerships (Anglo-Saxon system, UK and USA) that
assess value, buy, manage, sell the firm. There are 2 holders: limited partners and general partners.
Limited Partners (Pure investors) are not involved in strategic decisions. General partners that inject
money and provide managerial skills. GPs provide the “brain” (investment advisory): this is why
the get an annual management fee. This is a lucrative revenue. On average, 1.90-2%.

Ex: Blackstone will create a $40bn PE Partnership in infrastructure. One investor is PIF (Sovereign wealth fund of Saudi Arabia) with $20bn.

Management fee is 2% annum (huge!) received regardless of the investment performance.

Also, GPs get a portion of capital gains (incentive). LPs get the remaining part of capital gain, but
after having paid the fixed % to GPs. X% is called carried interest. On average, 20%.

Closed-end funds (Continental EU): fund with a closed and finite life. Two categories of investors
are:
 Investors: like limited partners before, they are providers of money.
 Management company: like general partners above (SGR authorised by Bank of Italy), it
provides investment advisory / management services. In some legislations it must also
provide money.
 
Both categories provide money to the fund and the fund can operate 3 strategies as above: direct
investment, co-investment and fund of funds. At the end of life of the vehicle, the vehicle
distributes to investors the capital repayment and capital gain. It also pays annual management fees
to management company and x% of capital gain of the fund, if the fund is successful.
 
Both LLP and provider of funds have a finite life and are closed (you remain involved in the
investment till the end because it’s illiquid). The typical life cycle is 10-12 years:

 
 
At the end, the vehicle must be empty: all the money must be returned to the investors. Before time
0 – fundraising: short and effective if you’re an important player. Raise commitment. During this
phase GPs start looking for investors (scouting the market) and propose their investment vehicle
raising commitments just commitments). If it is successful (reached target amount or
oversubscribed), you can start phase I.
Phase I is called investment period (4-5 years). You can call the commitments of the investors to
make the investment. This is your deadline to invest and you must exhaust the dry powder within
those 4-5 years to meet the promise made to investors (they committed their money behind your
promise that you could invest it).

 Screening
 Negotiations
 Buy out companies (direct and direct investments)

During management period: you screen companies, intervene in BoDs etc. The extra-grace period:
can be given by authorities only if you are managing pure assets. Only used to optimize the
divestiture process. From y5 to y10: you try to exit via IPO, via trade sale etc.  divestitures.

The definition of private equity is based on two different aspects we must have in mind every time
we deal with this issue. On one end private equity is a source of financing for a company. That

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means a private equity is an alternative of other sources of financing like an IPO or bond issuing or
getting a loan from the banking system. On the other hand, private equity is an investment made by
a financial institution, we name private equity investor.
Despite the fact that we have very different legal entities, the functioning of private equity behind
the legal entities is exactly the same, because it is based on two different players working together.
On one hand, we have managers managing the money of investors that are the other players, that
decide to commit their money into certain legal entities.
The last aspect we have seen was the understanding profit mechanisms. That means we have seen in
which way both the AMC and the investors are going to receive profit. What we discovered is that
coming from the best practices in the market, the AMC is going to receive two different types of
profit or revenues. The two types of revenues are represented by management fee and current
interest.
 

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