Alternative Investments

Universidad de Montevideo

Master de Finanzas

Septiembre 2021
Private Equity
Agenda

I. Introduction to Private Equity

II. Types of PE

III. Important considerations

▪ Valuation Methodologies
▪ Exit Strategies

IV. Market Trends & Challenges

2
I. Introduction to Private Equity
Definition

Fuente: Julius Baer 4

 Definition

▪ In its broadest sense, private equity is an ownership interest in a company or portion of a company that
is not publicly owned, quoted or traded on a stock exchange

▪ In financial terms, private equity generally refers to equity-related finance designed to bring about
positive change in a company, such as:
▪ Growing a new business
▪ Bringing about operational change
▪ Financing an acquisition
▪ Taking a public company private

▪ Because private equity returns are achieved through operational improvements and financial
restructuring, the experience and leadership ability of the private equity manager are paramount.

Fuente: BlackRock 5
 Definition

The compelling case for private equity

▪ The factors that drive returns in public equity markets have little or no impact on private equity,
enhancing private equity’s diversification potential.

▪ Private ownership enables long-term strategic focus as opposed to the public market focus on quarterly
earnings. This “patient” perspective has the potential to generate significant return on investment.

▪ As a whole, private equity has exhibited attractive performance on both a risk-adjusted and an
absolute basis.

Fuente: BlackRock 6
 Definition

Private equity: Comparison to public equity

Fuente: BlackRock 7
 Definition

The investor’s role:

Generally, investing in private equity involves three phases:

1. Capital Commitment. An investor signs a legally binding agreement to pay a set amount of
capital to a fund over a period of time, usually 3 to 5 years.

2. Drawdown. The fund manager draws down (i.e., "calls") the investor's committed capital in
increments as the manager finds attractive investments, typically with notice between 5 and 15
days beforehand.

3. Distributions. The investor receives distributions as the manager "exits" investments (i.e., sells or
takes the company through an initial public offering). These distributions are usually paid to the
investor as cash, but sometimes they can be used to offset future drawdowns

Fuente: BlackRock 8
 Who is investing in private equity?

• Public and private pension funds as well as sovereign wealth funds & government agencies represent
over 70% of total private equity funds under management

• US. pensions, the largest source of private equity capital, have more than doubled their alternatives
allocations since 2006* and the majority of these assets were invested in private equity

Fuente: BlackRock - Preqin Investor Intelligence, March 2016. 9

PE: Advantages & Disadvantages
Advantages
• Participate in markets not available through
traditional financial instruments.
• Participation in market environments where
traditional instruments offer few opportunities.
• Professional management with performance
incentive
• Reduced portfolio volatility
• Opportunities for high returns at the expense
of long-term investments.
Fuente: Julius Baer
Disadvantages
• Liquidity constraints:
- Minimum investment period (lock-up periods)
- Not usually listed/illiquid participation.
• Predictability: draw-downs on the investment
amount and the cash flow of the return are not
determinable beforehand.
• Only accessible for
professional/institutional/accredited or
qualified investors.
• Lack of control: the quality of fund management
is crucial to the success of the fund.
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PE: Risks to be considered

Fuente: Julius Baer 11

 PE Returns

Private equity offers return enhancement and portfolio diversification

Fuente: BlackRock 12
PE Returns

Fuente: BlackRock 13
Manager Selection

High dispersion of outcomes across private equity managers

Fuente: BlackRock 14
 Manager Selection

▪ Manager selection is critical to generate superior returns

▪ Greatest risk of private equity investing is choice of fund
▪ Historically, there has been a very wide disparity between bottom and top quartile returns in both the US
and European private equity markets, particularly in venture capital

Fuente: BlackRock 15
 Manager Selection

There is strong persistence of returns in private equity, particularly for top-performing funds

▪ Ability to add value to a company is a learned skill; research suggests that future returns depend in
part on such managerial ability

▪ Successful managers have (1) access to “proprietary deal-flow” and (2) may be able to invest with better
deal terms (e.g. lower valuations or less restrictive debt covenants); this is especially true for VC funds
when negotiating start -ups

▪ Target companies may proactively seek managers with proven value add track record

▪ Difficult for new entrants to compete with established, top-performing managers (for many of the above
reasons)

▪ Ultimately, evidence suggests that a top quartile fund has a 35% chance of their subsequent fund
performing in the top quartile and only a 17% change of dropping to the bottom quartile

Fuente: BlackRock 16
Manager Selection

Fuente: BlackRock 17
 Important Concepts

▪ Private equity industry growth is perhaps best viewed through four metrics

▪ Total AUM is composed of dry powder and unrealized portfolio value.

▪ This puts private equity assets at a high of $3.65 trillion

Fuente: Deloitte - Private equity growth in transition 18

II. Types of PE
Types of Private equity

Private equities can be subdivided into two broad categories according to the development
phase of the company the investment is targeted at:

Venture capital Buyout capital

• Investment in young growth companies,
supporting development of business ideas and
products, the marketing and sales of new
products, and the expansion of business and
growth of the market share.
• The companies profit from financing as well as
from the know-how the investors provide.
• Investment in mature companies with the aim
of taking them over, supporting their expansion
and growth or facilitating a turnaround for
positive performance.
• Less risky than venture capital

Fuente: Julius Baer 20

i. Venture Capital
Venture Capital

22
Venture Capital

▪ Venture capital is the supply of equity financing to start-up companies that do not have a sufficient
track record to attract investment capital from traditional sources (e.g. the public markets or lending
institutions).

▪ Invest in private companies (portfolio companies) with significant growth potential

▪ Venture capitalists are actively involved with the companies they invest in

▪ High-risk business: many start-up companies fail and are dissolved. Furthermore, investors in venture
capital limited partnerships are typically required to invest their capital for 10 years or longer. Venture
capital is a very illiquid investment class. For these reasons, investors should expect to earn a return
premium for investing in venture capital compared to the public equity markets.

Fuente: CAIA Association 23

Venture Capital

▪ VC capitalists set expected target rates of return of + 30% or more to support the risks they bear

▪ Successful start-up companies funded by venture capital money include Cisco Systems, Google &
Microsoft.

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The Economic Impact of Venture Capital

▪ A recent academic study quantifies the long-term impact of venture capital on the U.S. economy.

▪ In their study, “The Economic Impact of Venture Capital: Evidence from Public Companies,” the
authors note that Apple, Google and Microsoft, three of the five largest U.S. public companies by
market capitalization, all received most of their early, external funding in the form of venture capital.

▪ Using public companies as their measuring stick, the authors conclude that of the 1,339 companies
that have gone public since 1974, 42 % (556) can trace their roots back to venture capital.

Fuente: NVCA - “The true impact of venture capital” 25 25

The Economic Impact of Venture Capital

▪ Of course, measuring the impact of venture capital based solely on public companies only
tells part of the story, an admission made clear by the authors in their analysis.

▪ Not all successful venture-backed companies make an IPO. More often than not they are
acquired by another company, usually one that has already gone public. Knowing this, how then do
you account for contributions of these venture-backed companies to the economy? Or what about
the network effects venture-backed public companies create?

▪ As the authors point out, “From Microsoft’s Windows to FedEx’s overnight deliveries, the
technologies developed by VC-backed firms have changed the world.” How do you account for their
impact on the economy and the American worker through greater efficiencies in productivity?
The truth is, you can’t—which is why the authors of the mentioned study admit that it’s likely they
understate the true economic impact of venture capital, leaving the door open to follow-on research.

Fuente: NVCA - “The true impact of venture capital” 26 26

Returns

Fuente: Cambridge Associates – U.S: Venture Capital Index – As of Q1 2019 27 27

Returns

Access the top-tier VC managers

▪ Return performance is very persistent in the private equity industry.

▪ Managers that perform well in one VC fund tend to perform well in their next VC fund
▪ This return persistence is very different from that of other asset classes like large-cap public
equities or fixed income, where the marketplace is much more liquid and competitive
▪ The most successful venture capital firms have an established track record of getting start-up
companies to an initial public offering (IPO) of stock. This allows them to attract investment
capital from their limited partners as well as proprietary deal flow from start-up companies seeking
venture capital
▪ The general partner of a better-performing VC fund is more likely to raise a follow-on fund and to
raise larger funds than a venture capital firm that performs poorly

Fuente: CAIA Association 28 28

Sources of VC Financing

▪ The structure of the venture capital marketplace has changed considerably since 1985. What is most
notable is the change in leading sources of venture capital financing.
▪ Over the 1985–1990 period, pension funds accounted for nearly 70% of all venture capital funding …
▪ To replace the decline of pension funds and government agencies, three new sources of venture capital
funds have grown over the past 20 years:
1. Endowments and foundations
2. Intermediaries (such as private equity FoF, consultants, and even hedge funds)
3. Family offices

Fuente: Deloitte 29 29
The “J Curve” for a start-up company

Fuente: CAIA Association 30 30

ii. Leveraged Buyout
Leveraged Buyout

▪ Leveraged buyouts (LBOs) are a way to take a publicly traded company private, or a way to put a
company in the hands of the current management, sometimes referred to as management buyouts
(MBOs).
▪ This is a form of mergers and acquisitions (M&A) activity.
▪ Typically, the loans and bonds issued to purchase the outstanding public equity are secured by the
underlying assets of the company being acquired.
▪ The term leveraged is used to indicate that, after the buyout, the debt-to-equity ratio is much greater
than before the acquisition.
▪ In fact, the debt-to-equity ratio can be as high as 9 to 1, where the capital structure of the company
after the buyout is 90% debt and 10% equity.

Fuente: VC Journal 32 32
Leveraged Buyout

▪ Acquire companies through significant debt financing

▪ LBOs capital structure compromises equity, bank debt and high yield bonds

LP ($) 20 % EQUITY
PC 1 70% BANK LOANS
PE FIRM 10% HIGH YIELD
GP ($)
PC 2
LP ($)

Two Types of LBOs: Target Companies (PC) for LBOs:

▪ MBO: current management team • Undervalued stock price
purchases and runs the company • Lots of physical assets
▪ MBI: Current management is replaced • Inefficient companies
and acquirer team runs the company • Low leverage
• Strong and stable cash flow

33 33
Returns

Fuente: Cambridge Associates – U.S: Venture Capital Index – As of Q1 2019 34 34

III. Important considerations
Valuation Methodologies

Fuente: Deloitte 36 36
Valuation Methodologies
▪ Net Assets
▪ Value the business based on the value of its net assets
▪ This method is appropriate for business whose value is taken form the underlying fair value of its
assets rather than its earnings
▪ Example: property holding company, which holds a number of properties with prices available for
those properties

▪ Price of Recent Investments

▪ Method uses price of recent transactions
▪ Only valid for a limited period following a relevant transaction (1 to 2 years)
▪ Changes or events subsequent to the relevant transaction which could indicate changes to the
investment fair value should be assessed

▪ Discounted Cash Flow

▪ Value the business by calculating the NPV based on the expected future cash flows

Fuente: Deloitte 37 37
Valuation Methodologies
• Earnings Multiple
• Application of an “Earnings Multiple” to the earnings of the business being valued
• This method is likely to be appropriate for an investment in an established business with a stream
of continued earnings e cashflows that are considered to be maintainable

• Industry Valuation Benchmarks

Fuente: Deloitte 38 38
Exit Stategies
1. Initial Public Offering (“IPO”)
▪ IPO is the method whereby the company’s shares get listed on the stock market for the first
time, so the investor will be able to sell its shares to the public.
▪ This is one of the most popular exit strategies used by private equity providers, due to the fact
that when the proper market conditions are available, this method is likely to enable the investor to
realize the highest return on its investment.
▪ Notwithstanding the higher outcome that can be obtained, IPOs also have serious disadvantages
compared to other exit methods that need to be taken into consideration.
▪ The public offering of shares in itself does not mean an exit. The PE provider will only be
able to exit its investment when its shares are actually sold on the stock market, which is
very unlikely to happen simultaneously with the IPO. Therefore, the investor seeking to
perform an exit will be exposed to fluctuations and other market risks for a certain amount of
time after the IPO is carried out.
▪ The listing of the shares of a company is typically subject to strict regulatory requirements
and restrictions, which make the IPO a lengthy and expensive process.

Source: Hungarian Private Equity and Venture Capital Association 39 39

Exit Stategies
2. Trade Sale
▪ Another commonly used exit route is the trade sale in which the private equity investor sells all of
its shares held in a company to a trade buyer, i.e. a third party often operating in the same
industry as the company itself.
▪ This method is preferred by private equity providers mainly because it provides a complete and
immediate exit from the investment.
▪ Another advantage of the trade sale is that in this case, the negotiations take place with a single
buyer which allows for a quicker and more efficient process which is not subject to the regulatory
restrictions applicable to IPO transactions.
▪ On the other hand, trade sale is not free from potential problems and risks either.
▪ The management of the company may be resistant such a transaction as the change of
control often results in the replacement of the company’s management as well.
▪ A trade sale might also entail serious business risks as the buyer is oftentimes a
competitor of the company, which will inevitably obtain confidential business information
during the negotiation process.

Source: Hungarian Private Equity and Venture Capital Association 40 40

Exit Stategies
3. Secondary Buyout
▪ The company is sold to another PE firm. In other words, the particular nature of a secondary
buyout lies in that PE houses appear on both sides of the deal, while in the average transaction PE
investors would only be involved either as seller or purchaser.
▪ There are a number of possible reasons why an investor may choose this method as the exit route.
It can be a means of shortening the life-time of a transaction which has become a priority for
private equity houses in the recent economic climate, and therefore secondary buyouts have
become increasingly popular. Sometimes, the investor which carried out the original acquisition is
not willing to (or cannot) finance a business anymore, even though the company might not yet
be ready for a trade sale or IPO. In that case, selling the company to another private equity firm
which sees potential in further developing the company might be a reasonable solution.
▪ A secondary buyout offers the advantages of an immediate and complete exit and it can be
carried out even faster than a trade sale or an IPO. This plays a significant role in its increasing
popularity.

Source: Hungarian Private Equity and Venture Capital Association 41 41

IV. Market Trends & Challenges
 Market Trends
“Barbelling” of the Investment Industry

▪ What Morgan Stanley terms the “barbelling” of the investment industry: money gushing into either cheap,
index-tracking vehicles or expensive, often complex “alternative” investment funds — has left many
traditional asset managers struggling.

▪ The attraction of private capital is twofold: it holds the promise of higher returns at a time when the
outlook for mainstream public markets has dimmed; and the private, untraded nature of the assets mean
they are less volatile.

• BlackRock survey of 230 institutional investors with more than $7tn under management revealed that
51 per cent of the respondents planned to trim their exposure to public equities — but almost half
intended to put more money into private markets.

Source: Financial Times as of Oct 2019 43 43

Market Trends

Source: Financial Times as of Oct 2019 44 44

Market Trends

Source: Deloitte Intelligence 45

Market Trends

Source: Deloitte Intelligence 46