Private Equity

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1.1 Overview of Private Equity

Private equity is finance provided to unquoted private companies in exchange for equity (and other) capital in that company. It can be provided at a number of stages in a company’s life cycle:

• Start-up, early stage businesses: at this stage, it is referred to as , and is discussed in more detail in the next chapter. • Development capital. This is capital provided to established, cash generative companies to help them move to the next stage of their development. • Expansion capital. Again, capital provided to established, cash generative companies, to help them grow in terms of scale or scope; perhaps by allowing them to develop new products, increase production facilities or expand into new markets. • Acquisition finance. This is capital provided to a company to help finance an acquisition of one or more other enterprises. • Management buy-outs or buy-ins. Capital provided to a management team, to enable them to buy a business. In the case of a management buy-out (MBO), this capital is provided to incumbent management. In the case of a management buy-in (MBI), this is provided to in- coming management. Where incumbent management co-operate with incoming management, this is referred to as a buy-in management buy-out, or BIMBO. • Secondary buy-outs. This is capital to buy out the interest of an incumbent venture capital or private equity investor; one investor replaces the other by acquiring its equity interest.

• Rescue/recovery finance. This is capital provided to a company in financial difficulty, to enable it to survive, restructure and recover.

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The common theme in each of these stages is that the finance is provided when:

a) the company needs finance to achieve a change. This could be expansion, change of control or survival; and b) for one reason or another, the company’s financing needs cannot be met in full through the mainstream sources of bank finance or the equity capital markets; ie, the company has a funding gap.

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2.1.1 The Goals of Private Equity

At its simplest, the private equity process can be summarized as:

Find >>>> Buy >>>> Change >>>> Sell

1. Find: The private equity firm identifies investment opportunities meeting its specific investment criteria, that have the potential for high returns. 2. Buy: The firm makes an equity investment in the business concerned, ensuring that it secures a reasonable degree of control. 3. Change: During the investment period, the firm expects to see an uplift in the equity value of the investment, through changes to management, strategy, structure or financing. 4. Sell: The firm plans to exit each investment within a time period of, say, three to five years, by way of an IPO or trade sale.

At the end of the investment period, the private equity firm hopes to have seen a profit on its investment, through a combination of dividends, interest, fees and capital gain. This can be expressed as either: • An internal rate of return (IRR; that is, an average annual compound return on investment) appropriate for the risk of its investment. This return should be well in excess of the return it could have achieved in in the public equity markets; a rough rule of thumb suggests that many firms are looking for an IRR of 30% on their portfolios. • A money multiple/cash multiple. This is a simpler calculation, reflecting just the proceeds on exit together with any dividends or interest received, as a multiple of the total investment.

Example

In September 2006, acquired NES Global Talent, a recruitment business, in a £70 million management buy-out. Over the next six years, the investors and management internationalised the business; EBITDA increased six-fold, and its overseas markets more than doubled. In November 2013, Graphite sold the company for £234 million. 3

2.2 Private Equity Firms

So, who are the private equity firms? With the exception of certain forms of venture capital, private equity finance is provided by professional investment entities, but these vary considerably in terms of their size, investment approach, risk appetite and modus operandi. In this chapter, we will look first at the most typical features of private equity firms, and then touch on some alternative structures.

Private Equity Funds

The majority of private equity (by value) is invested through private equity funds. These are collective investment schemes, where finance is contributed by a number of investors, pooled in a fund, and then invested by the fund manager (in this case, the private equity firm).

The majority of funds are structured as limited partnerships rather than as incorporated companies, with the investors and the private equity firm all being partners.

The private equity firm takes the role of general partner (GP) in the fund. As GP, the firm generally invests its own capital in the fund, alongside the external investors who are limited partners (LPs) in the fund.

General Partners and Limited Partners

The limited partners are the underlying external investors in the funds. They are typically a mixture of high net worth individuals (HNWIs) and investing institutions, which include pension funds, insurance companies, family offices, endowments, charities and sovereign wealth funds. LPs take a ‘hands-off’ role in the management of the fund and identification of investments. Their liability for the obligations and debts of the fund is limited to the amount of capital they have invested; ie, they cannot lose more than they have invested.

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The general partner is the hands-on investor, and is usually the sponsor and the manager of the fund. The GP’s liability for the obligations and debts of the fund is unlimited. The GP is responsible for:

• Fund raising: identifying potential investors and marketing the fund to them, promoting the fund on the basis of the past performance of the GP’s prior funds as well as current investment focus; the fund must have sufficient critical mass to achieve its investment aims. • Identifying and analyzing potential investments: ensuring that the fund invests only in those investments with the potential to generate a significant return for the private equity firm, and carrying out research into their products, potential markets, management teams and r i v a l s . • Negotiating and structuring investments: ensuring that the fund’s individual investments are protected as far as possible, through negotiation of shareholder/investor agreements, board representation and differential share structures. • Monitoring investments: in private equity, the investor expects to have a very active engagement with its portfolio companies, including appointing a representative director to the board, reviewing budgets, forecasts and management accounts, leading discussions with banks and other investors, and influencing strategy. • Arranging follow-on capital: for earlier-stage businesses, finance is generally provided on a ‘stage-by-stage’ basis, with each stage of investment being negotiated separately. If the company doesn’t meet its stage one targets, or comply with its obligations under the investor agreement, stage two capital may not be available. • Arranging the exit: in due course, exiting each investment in order to generate a return for the fund’s investors. • Managing the fund: ensuring that the day-to-day administration of the fund is properly carried out, that LP funds are drawn down in time for investments to be made, and that returns are properly paid out to the LPs.

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Limited Partnership Structures

Limited liability partnerships are widely used in private equity and venture capital funding, because they provide a tax-efficient, lightly regulated, internationally convenient investment structure. The partnership is tax transparent; that is, the profits generated by the fund in the form of dividends, interest or capital gains are not subject to corporation or other tax; instead they are distributed gross to the LPs. LPs are of course responsible for paying any tax due in respect of their individual profits and dividends.

Most funds are structured as closed end funds: that is, they are established in order to raise a particular sum of money, and once this has been raised the fund is closed. LPs’ interests cannot be redeemed, and no further investors can be admitted, during the term of the fund.

Example:

Argos Partners started marketing a £600 million global recovery fund in January 2007. By March 2007 they had raised commitments of £500 million from external investors, and announced the first closing. At this stage, the firm entered into binding partnership agreements with these external investors and could start identifying investments, while they continued to market the fund in the hope of raising the final £100 million. By July 2007 the full £600 million was raised from additional external investors, and Argos announced the final closing, entering into partnership agreements with these investors.

When a private equity firm is raising a fund, LPs are invited to make commitments to provide capital to the fund. Only a small proportion of these commitments is drawn down at the fund closing – just enough to meet the operating requirements of the fund – and the balance is ‘drawn down’ from the LPs in stages as and when required for individual investments, usually with around two weeks’ notice being given.

Most funds are also established for a limited term, typically ten years from closing, with an optional extension (at the GP’s discretion) for one or two further years. During that ten-year period, the GP is responsible for identifying, analyzing and making investments. As and when an investment is agreed, the GP gives notice of the required drawdown to the LPs who are required to contribute, up to the level of their commitments.

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Frequently a fund has a five- or six-year commitment period, starting from the fund closing. If the GP has not managed to negotiate sufficient investments to invest the entire fund, then any outstanding LPs’ commitments are released; this encourages early investment by the fund.

Example:

Following on from the ‘Argos’ example above: the Argos Recovery fund had a six year commitment period, starting from the July 2007 close. By July 2013, the fund had only invested £450 million of the total funding (75% of the total). At this stage, the LPs had provided 75% of their individual investments, and were still committed to providing the further 25% when requested. However, once the commitment period ended, LPs were no longer obliged to provide the further 25%, and in most cases the fund will cease to invest in further opportunities.

The activities of the fund are set out in the fund agreement, which is a contract between the LPs, the fund and the GP. It might be a generalist fund, or it might have a particular investment focus: for example it might be a recovery fund, or a buy-out fund. The fund agreement will also set out any restrictions on the fund’s borrowing and investing powers, as well as provisions for co-investment alongside individual LPs or other funds, and profit sharing provisions. In addition it states the fund’s target return in the form of an internal rate of return (IRR), and sets out details of the past performance of other funds managed by the private equity firm, expressed as an IRR or as a multiple of funds invested.

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Over the life of the fund, the GP invests in a portfolio of individual companies, through equity and/or debt instruments as appropriate for each investment. Its intention is to exit each investment within a optimum timescale – say, three to five years – with a preference for an exit by trade sale or IPO. Over the life of each investment the GP, through its investment executives, maintains a close relationship with the management of each company and monitors their performance regularly against t a r g e t s .

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Profit Allocation in Limited Partnerships

The GP in a receives the following payments:

1. A , typically an annual fee of 2% of total commitments. Once the commitment period is ended, this fee usually reduces to 2% of the funds actually invested. 2. Investment costs, including due diligence, legal and accounting fees, up to pre- determined limits. The extent and type of costs reimbursed is set out in the fund agreement. 3. . This is the GP’s share of the profits of the fund, and is calculated as shown below.

Any cash flows generated by the fund, in the form of dividends, interest and exit proceeds, are divided between the GP and the LPs as follows:

1. Annual management fee and investment costs are paid to the GP, as described above.

2. In the early stages, all further cash flows generated are allocated and paid to the LPs, until their return has reached a hurdle rate set out in the fund agreement – for example, 8% of their total commitments. 3. Once the hurdle rate is reached, any further cash flows generated are shared between the GP and the LPs, typically in the proportion 20:80. This 20% share of the profits is referred to as the GP’s carried interest.

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Alternative structures

The larger private equity firms may also raise funds from the equity capital markets. The UK’s is a company that is listed on the main market of the London Stock Exchange. It invests its own capital direct in private equity investments. Some of the larger international private equity firms have also raised funds through the public equity markets. For example, (KKR), which is one of the best known and oldest established firms, raised $5 billion in an on Euronext for a newly incorporated investment vehicle, KKR Private Equity Investors.

A stock exchange listing allows pension funds, insurance companies and other investors to invest in private equity indirectly, through their ownership of listed shares, which gives them more liquidity and transparency than an investment through a ten-year limited partnership. However, listing, and maintaining a listing, significantly increases the firm’s cost base and regulatory burden.

There are also a number of public sector private equity initiatives. These include regional funds, such as Finance Wales, which provides finance for Welsh small and medium enterprises; and international funds such as CDC, the UK’s Development Finance Institution.

2.3 Attracting Private Equity

Businesses seeking to attract private equity must, above all, be able to demonstrate the potential for growth, and must also have strong, effective management.

Growth could come from:

• Fundamental growth: expansion of sales through development of new products or new markets for those products. Where the business can demonstrate the potential for growth in both the short-term and long-term, so much the better. • Structural change: altering the company’s revenue model or cost base, to increase revenue or improve profit margins, will lead to an improvement in profitability and

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thus a growth in enterprise value. Structural changes could include reducing operating expenses or cost of sales (raw materials and production costs), or changing the company’s production processes, distribution networks or indeed its entire operating model. • Improved efficiency: better management and new ownership could improve the company’s profitability, increase sales and enhance return on capital employed.

• Financial restructuring: re-leveraging a company, to reduce its cost of capital, can have the effect of increasing its equity value, as well as increasing the capital available to fund expansion. Alternatively, the firm’s strategy could involve restructuring of a company that is over-leveraged, to enable it to survive and grow.

2.3.1 The Business Plan

The first critical step in attracting private equity is for the management team to prepare a business plan. This is the team’s first opportunity to ‘sell’ their proposition to investors, and it may well be their last, as only the most compelling plans will be followed up. The contents of the business plan are summarised in the following chapter, on Venture Capital, and so are not duplicated here.

2.3.2 Identifying and Approaching Investors

Once the business plan is complete, the management team should identify suitable investors. The main regional private equity industry organizations provide directories of private equity firms – for example, the British Private Equity and Venture Capital Association (BVCA) publishes a directory of its some 170 members, showing details of each private equity firm’s investment focus, preferences in terms of region, stage and size, and contact details. This is an area where specialist financial advisors can add significant value, as they should have industry contacts and be able to provide advice on which firms to approach, and how.

Most private equity firms prefer to see investment opportunities that have been introduced by 11 professional firms, father than unsolicited business plans, as this provides them with some pre- screening. Generally an advisor approaches a restricted number of firms that it considers are appropriate in terms of their investment preferences, and provides them with the executive summary, which may be given on an anonymous basis. If the private equity firm is interested in seeing the business plan, it would be asked to sign a non-disclosure agreement before the plan is released.

2.3.3 The Next Steps

The private equity firm’s evaluation may go through a number of stages.

Initially, one investment executive from the firm will review the business plan and, if it looks interesting, may discuss it with his or her peers. The procedure will of course vary from firm to firm. If the decision is taken to investigate it further, then at this stage the management team may be asked for more information, or they may be invited in for a meeting, to present their business case to the private equity firm. This meeting is aimed at evaluating the strengths of the management team, as well as clarifying the merits of the underlying business proposition.

If the management team has been able to convince their potential investors of the strength of their business case, then the next stage is to enter into negotiations. These will centre on two main areas.

• The financing itself: how much is to be invested, and what form will the finance take? How much of the equity will the private equity firm hold? • Securing the investors’ position: what are the obligations and restrictions of management, and what covenants will be required?

These topics are discussed in more detail later in this chapter.

Once agreement is reached in principle – with the assistance of financial advisors, tax advisors and lawyers – the private equity firm commissions due diligence.

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Due Diligence

Due diligence is best described as a full investigation into the current position, past record and future prospects of a business, using specialist advisors to inspect and evaluate the financial, legal and other records of the company. In the case of private equity investment, there will also be a considerable focus on commercial due diligence, covering research into the proposed and existing markets, customers, suppliers and competitors of the company.

Most private equity firms also carry out management due diligence. Each member of the management team is required to complete a detailed management questionnaire, covering their personal and financial status, employment and other experience, education and qualifications. The management will be required to warrant the accuracy and completeness of the information provided, and this will form the basis of the due diligence investigation.

Provided that the due diligence is satisfactory, management and the private equity firm can then move forward in their negotiations, to reach final agreement on the terms of the investment.

2.4 Private Equity Deal Structures

The principles underlying most private equity deal structures are:

• Provision of an adequate return for both the and the management team, relative to their respective risks and contributions; • Ensuring that the management team is financially and legally committed to the business throughout the investment period, and that the private equity firm has strategic and voting control; and • Use of the maximum leverage that is compatible with the company’s risk profile.

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In this section, we will look first at the financial instruments that may be used in structuring a private equity deal, and then at an example deal structure.

2.4.1 Financial Instruments

A private equity firm will usually invest through a combination of equity (ordinary shares), preference shares and/or loan stock.

Ordinary Shares

Investing through ordinary shares gives the private equity firm voting rights, dividend rights, and a right to participate in a winding up or, more importantly, on a sale or IPO of the business at the time of exit. It is usual for the firm to structure the transaction so that it takes shares of a different class to those of the management team; for example, the private equity firm may take 100% of the ‘A’ ordinary shares whilst the management team holds 100% of the ordinary shares. The respective rights of each side depend both on the total number of shares, and the rights set out in the company’s Articles of Association.

It is common for the investors’ shares to carry enhanced dividend and voting rights while the management shares carry none, or have reduced rights. Alternatively, management may be allotted deferred shares, where the rights will vest only after pre-agreed targets are met.

Example:

A company has 60‘A’ ordinary shares and 40 ordinary shares in issue, with management holding the ordinary shares and the private equity firm holding the‘A’ ordinary shares. The‘A’ ordinary shares each carry two votes compared with a single vote for each ordinary share, so that the private equity firm holds 60% of the shares but has 75% of the voting rights.

Preference Shares

Some of the private equity firm’s investment may be in the form of preference shares. This has a number of advantages. Firstly, as we have seen in Chapter One, preference shares are very flexible instruments. They may be redeemable, convertible, dividend-paying, profit-sharing, cumulative

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As an example, the private equity firm might invest through a 2017 convertible redeemable cumulative 5% preference share. Its return would depend on progress of the investment, as follows:

Dividend: if the company generates sufficient profits and cashflows to pay a dividend, the private equity firm is entitled to a dividend of 5% of the face value of the preference shares. If there is no cashflow, this 5% dividend is carried forward as a liability of the company, to be paid once it is profitable. This dividend is paid in priority to any dividend declared for the ordinary shareholders. Note that, if this was a participating preference share, it would also entitle the holders to a set proportion of the company’s profits.

Redemption/conversion: in 2017, the private equity firm has the option of either redeeming the preference shares at face value, or converting them into ordinary shares based on a formula agreed during the deal negotiations. If the investment has gone according to plan, they may seek to convert the preference shares into ordinary shares, giving them a greater share of the exit proceeds. If it has not gone as planned, and there is relatively little value for equity shareholders on exit, they may decide to redeem the preference shares at face value.

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Example:

A private equity firm holds £10 million of convertible redeemable preference shares in its investment, and owns 50% of the 1,000,000 ordinary shares. The preference shares are convertible at a rate of £10 = 1 ordinary share.

• On exit, the sale proceeds after debt repayment are £24 million. If the firm redeems its preference shares it will receive the face value of £10 million, plus 50% of the remainder: ie, a total of £17 million. Alternatively, if it converts its preference shares into equity, it will not receive the face value of the preference shares but instead will receive a further 1 million shares. Its total holding increases to 1.5 million shares, 75% of the total. Its proceeds on exit would therefore be £18 million (75% of £24 million). • If however the sale proceeds after debt repayment are just £15 million, then (following the same calculation process) on redemption of the preference shares the firm would receive £12.5 million; on conversion into ordinary shares it would receive £11.25 million.

Where a separate class of convertible redeemable preference shares is allotted to management, these can be used as an incentive tool; if management meet their targets, their preference shares are converted into ordinary shares, giving them a greater percentage of the equity.

Loan Notes

Loan notes are very similar to preference shares in that they too can be convertible, redeemable, interest- bearing, profit-sharing or any combination of these. However, there is a key difference, in that loan notes are debt instruments. The significance of this is that:

• Loan notes rank ahead of preference shares in a liquidation, and rank alongside all other debt with the same level of security. This creates an additional level of comfort for the private equity investor. • The interest on loan notes, as with most other debt, is tax-deductible. This creates a cash tax saving for the investee company and this, of course, benefits its investors. • The loan notes are included with all other forms of debt in calculating the

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investee company’s gearing and other ratios for financial covenant purposes.

If the investee company has sufficient debt capacity, the private equity investor will usually choose loan notes over preference shares in structuring the deal.

(Note: for accounting purposes preference shares may also be included as debt – depending on the accounting regime in force – and some banks will also take them into account in the covenant calculations; but they are not classified as debt when it comes to the tax treatment of dividends.)

Debt

In some cases the private equity firm may structure part of their investment as debt. This is most common in early stage and start-up businesses, which are cash-negative and therefore have no independent ability to raise debt from third party lenders. In this case, the element of the finance that is structured as a loan would be secured on the investee company’s assets – whether tangible or intangible. This gives the private equity firm priority over all forms of equity as well as over unsecured creditors, bringing with it a degree of risk mitigation.

For later stage investments, it is often possible to raise secured debt from a third party lender. In this case, the private equity firm may provide additional debt, in the form of a subordinated or mezzanine loan alongside its equity investment.

Mezzanine debt is a loan that shares some of the features of both debt and equity. It is debt that is subordinated, in terms of collateral, interest and repayment, to other loans. As this subordination increases the risk profile of the loan, the cost of the debt is high and it is not uncommon to find mezzanine with a total cost of, say 12–15%, or higher. For a developing, higher-risk company, an interest rate at this level would add a prohibitive burden to its cashflows, so the lender’s return is split between interest (at, say, 10%) and an equity ‘kicker’ to increase the total potential return. The equity element is normally in the form of warrants to subscribe for new shares in the borrower, exercisable on the earlier of repayment and exit. Alternatively, part of the debt could be convertible into equity. 17

The term ‘mezzanine’ comes from the fact that this form of funding falls right between the ‘ground floor’ of senior debt and the ‘first floor’ of equity. In larger deals, mezzanine may be introduced as a temporary loan, taken out in order to complete the business acquisition but intended to be refinanced in the high yield markets, through the issue of a high yield bond, when market conditions allow.

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Example:

Premium Investment Inc is negotiating a £150 million investment in Troy Ventures. A commercial bank has agreed to lend £100 million as a senior secured five-year term loan, leaving a funding gap of £50 million. Premium believes that Troy’s cash flows will support £25 million additional debt and so has the option of approaching another third-party lender, or providing the additional debt itself.

The additional debt is structured as follows:

£25 million mezzanine with a term of seven years; no repayments until senior debt is repaid in full and then bullet repayment on change of control; fixed rate interest of 10%; warrants to subscribe for new shares representing 3% of the enlarged equity in Troy, exercisable on repayment of the debt OR on change of control, whichever is earlier. This is in addition to full repayment of the debt.

Other Sources of Finance

Other sources of finance may be available, and some of these could reduce the total funding required.

• Vendor finance is finance that is provided by the vendor of the underlying business. For example, this could be a parent company agreeing to provide working capital facilities, guarantees or loan finance for all or part of the investment period. • Grants, loans and guarantees may be available from regional, national or international sources; for example, the UK government’s Enterprise Finance Guarantee Scheme and the European Investment Fund’s JEREMIE initiative provide guarantees for loans to viable smaller companies. • Leasing finance involves entering into a financial lease or an operating lease in order to acquire fixed assets such as plant, machinery or real estate. This is treated as debt finance, both for accounting purposes and in terms of the lending covenants, but can be a tax-efficient and lower-cost way to raise asset finance. • Deferred consideration is not strictly a source of finance, but is a means of reducing the

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amount of finance that has to be raised up-front to fund an acquisition. Here, the vendor agrees to delay the payment of part of the acquisition consideration until some later, pre-agreed date. • Factoring is working capital finance; the company enters into an agreement with a factoring company (often part of a banking group) whereby it transfers its trade receivables to the factor, in exchange for (say) 80% of the value up-front. The factor takes responsibility for collecting these sums due from the company’s customers, and pays a further sum to the company once this is completed. Although this is not structured in the same way as a loan, it reduces the company’s assets available for collateral and may therefore reduce its debt capacity.

2.4.2 Investor Agreements

At the same time as agreeing the deal financing, the private equity firm and the management team must agree the terms of their relationship as co-operative investors in the investee company. These terms are set out in an investor agreement, and reflected in the new company’s Articles of Association.

Some typical provisions of the investor agreement are as follows.

• Drag-along/tag-along rights. These are provisions that have the effect of ensuring management’s co-operation on exiting the investment, and also provide them with some protection on exit. The drag-along right gives the private equity firm the right to force management to sell their shares if the private equity firm decides to exit. In parallel, the tag-along right gives the management the right to sell their shares if the private equity firm chooses to exit, on equivalent terms. • Pre-emption rights. These provide that if any member of the management team wants to sell his or her shares (with limited exceptions) then those shares must be offered in the first instance to the private equity investor and in some cases to the other members of the management team. The price to be paid for the shares depends on the reason for the sale, as a sale is generally only possible when the manager leaves the company. • Good leaver/bad leaver. These provisions are designed to keep the management team committed to the business over the life of the investment. A ‘good leaver’ is generally one who has left the company due to death, grave illness or disability; a ‘bad

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leaver’ is one who has left the company for any other reason. A bad leaver must sell his or her shares on a pre-emptive basis (see above) but the price he receives may be just the nominal value of the shares. A good leaver would expect to receive a fair value for the shares. • Information and representation. This gives the private equity investor the right to appoint one of their executives to the board of the investee company; usually, any board meetings held without the investor representative present are deemed to be non- quorate, and therefore its decisions are invalid. In addition, management must commit to providing their investors with information (such as management accounts, budgets, forecasts, cash balances, etc.) by the deadlines set out in the agreement. • Management restrictions. Certain management actions will require the prior approval of the private equity investor. This may include capital expenditure, recruitment of staff, major new contracts, entering into new lines of business, payment of bonuses or dividends and sale of assets. • Rights attaching to shares. This section will set out the respective dividend, voting and distribution rights of the management vis-à-vis the private equity investors.

• Covenants. Where the investment includes a debt element (whether senior, mezzanine, working capital or loan notes) the agreement also includes the financial performance measures that the management team must commit to. This might include maintaining working capital at a certain level, maintaining interest cover, and ensuring that the net debt: EBITDA ratio and gearing ratios do not rise above set thresholds.

The overall theme of the investor agreement is protection of the private equity investor’s position, and ensuring that the management team is committed to stay and work with the business, and help to achieve a profitable exit.

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2.5 Private Equity Exits

The timescale for private equity investment varies considerably; some firms aim to exit their investment within three to five years, but for many earlier stage businesses exits are far later, and if a business is highly successful the exit may be far earlier.

Generally a private equity firm will hope to exit in one of three ways:

• IPO: listing on an appropriate stock exchange. This will give the investors the option of partial divestment of their shares, if they choose to continue to invest, and will also give management the ‘kudos’ of being directors of a public company. However, an IPO is an expensive process, its success is dependent on market conditions at the time, and it gives rise to a very substantial burden in continuing regulatory and disclosure obligations. Moreover, many smaller companies may struggle to meet the criteria for listing on their preferred exchange. • Trade sale: sale to a commercial purchaser. A trade purchaser in the same industry may be prepared to pay a higher price, based on the potential for synergies, and a sale can in some cases be relatively quick and inexpensive compared to an IPO. Its success depends on market conditions, relative negotiating strength and the existence of buyers; and a trade sale may not be the first choice of an ambitious and independent management team.

• Financial sale (secondary buy-out): sale to another private equity firm. A firm with a focus on early stage businesses might invest in a company for, say, three to five years to take it to the stage where it is well-established. It could then sell its equity investment to a private equity firm that specializes in development or expansion capital for established companies.

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In practice, there are two other possible exit routes:

• Management buy-back: management buying out the private equity investment. This is only a likely outcome when the investors’ stake has decreased so far in value that management can afford to buy them out, giving the private equity firm a ‘clean break’ from the business. • Liquidation / write-off: the investment has failed, and either it is insolvent (so that the business is being wound up) or the private equity firm writes off its investment as having nil value.

Example

In April 2008, 3i Group plc bought the Active Pharmaceutical Ingredients business of Alpharma, a NYSE- listed pharmaceutical company, and re-named it Xellia. It strengthened the company’s board and senior management, and over the next five years Xellia invested more than US$ 100 million in research and development and capacity expansion. In 2012, it expanded and developed its product portfolio and by 2013 was firmly established as a specialty pharmaceutical group focused on anti-infective therapies. In May 2013, 3i announced the sale of Xellia to Novo A/S, for an enterprise value of US$700 million. The return to 3i represented a 2.3x multiple on their original investment of US$208 million.

2.6 Example Deal Structure

In this final section, we will adopt a fictional example of the management of a company called FullDeck, seeking investment from the Solitaire private equity firm to finance a management buy-out. FullDeck is cash generative and profitable, and expects to generate EBITDA (earnings before interest, tax, depreciation and amortization) of £4.5 million in the first year of investment. It has £10 million of tangible assets available as collateral.

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The total funding requirement is as follows:

Acquisition finance: £25 million

Refinancing of existing debt: £5 million

Working capital: £2 million

Capital expenditure: £8 million

Fees, etc: £1 million

Total: £41 million

Management Contribution

The management team members are jointly able to contribute £1 million of investment, funded using personal loans and savings. This represents roughly one year’s salary for each of them: this is a sizeable commitment, but achievable, and a commonly-used rule of thumb for setting the management contribution in practice.

Senior Debt

The first stage in the process is to calculate the business’s debt capacity, using typical loan covenants as a guide. For this example we will assume that a third- party commercial bank might require a borrower to maintain senior interest cover (EBITDA divided by senior interest) of 4x. We will also assume that the bank would charge an interest rate of 5%.

• FullDeck is expected to generate EBITDA of £4.5 million in the first year; the maximum interest it could pay under this interest cover covenant is £1.125 million. • This maximum interest of £1.125 million is 5% of £22.5 million (£1.125 million divided by 5%); so the maximum senior debt FullDeck can raise is £22.5 million.

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So far, we have funding of £22.5 million in senior debt, and £1 million of management equity, giving us a funding gap to fill of £17.5 million.

Mezzanine Debt

Our next step is to see if there is any further debt capacity in the business. This is restricted by any further financial covenants imposed by the senior lender, as well as by FullDeck’s expected cashflows and profitability, and the risk appetite of Solitaire and/or management.

The interest cover covenant of 4×, shown in the previous step, related only to the interest on the senior debt. A senior lender will also impose restrictions on the total debt its borrowers can raise, in the form of a ‘total indebtedness’ covenant and a ‘total interest cover’ covenant. For this example, we will adopt a total interest cover covenant of 2.5×. This means that the maximum interest that FullDeck can pay, taking into account all forms of debt, is EBITDA divided by 2.5. We will also assume that the mezzanine interest rate is

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10%, and that the mezzanine lender will seek warrants entitling it to 5% of the diluted equity.

• FullDeck’s maximum total interest is £1.80 million (£4.50 million divided by 2.5). However, this figure includes the senior debt interest of £1.125 million, so that the maximum mezzanine interest is £675,000 (£1.8 million less £1.125 million). • The maximum mezzanine debt is therefore £6.75 million (£675,000 divided by 10%).

Our funding gap has now decreased to £10.75 million. There is no further debt capacity; and in the absence of any other sources of finance, this is now the private equity contribution.

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Private Equity

It now remains only to allocate the private equity investment between ordinary shares and preference shares. In this example we have absorbed the total debt capacity by taking on third party senior and mezzanine debt, so there is no scope to include loan stock in the funding mix.

The allocation decision is driven by a number of factors, including the following.

• The relative proportions of ordinary shares to be held by management and the private equity firm. This affects both relative voting rights, and the share of equity proceeds on exit. • Let’s assume that the private equity firm wants to hold a 51% stake in the business, giving it voting control. If the management team have subscribed £1 million for their equity interest (which will be 49% of the ordinary shares) then a 51% stake would require an investment of £1.04 million. • The balance of the private equity investment, £9.71 million would then be in the form of preference shares, whose terms will be depend on the company’s projected cashflows.

The shareholding split is important, particularly when it comes to allocating the share of exit proceeds, but in practice it is often more easily managed using different classes of shares with different nominal values and share premiums.

• The private equity firm’s required returns. This means that the investors must have a high enough share of the equity to give them an IRR of (say) 30%. The following simple example illustrates this (note that it ignores any dividend payments over the investment p e r i o d ). • Assume that the firm’s projections show an exit in year 5 for an enterprise value of £66.66 million. Assume also that the senior debt has been repaid over the life of the investment. After repayment of the outstanding mezzanine debt of £6.75 million, the total equity value is £59.92 million. • To achieve an IRR of 30%, the private equity investment of £10.75 million must increase to

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£39.93 million (10.75 × 1.35). This equates to 66.65% of the expected total equity value on exit; and so the private equity firm would seek to have 66.65% of the total equity.

• Ensuring a fair allocation of risk and reward between the investors and the management team. Management’s financial and personal commitment, relative to their own wealth, is far greater than that of the private equity firm, which invests only a small proportion of a fund in each portfolio investment. Management’s risk is far greater, and this suggests that their return on investment should be higher. Envy ratios can be used to evaluate the relative positions of management and the private equity firm. • As a reminder, the private equity firm is investing £10.75 million and expects to receive £39.93 million on exit, which gives a ‘money multiple’ of 3.71×.

• The management team invests £1 million, and expects to receive £19.98 million (£59.92 million less £39.93 million). This gives a money multiple of 19.98×. • The management multiple is 5.38× the investors’ multiple. This figure of 5.38 represents the ‘envy ratio’. A low ratio (below about 4) implies that management are under-incentivised; a high ratio (above about 7) suggests that that the private equity firm is being over-generous.

In practice, the final decision will be based on the proportions of equity and preference shares that optimize the investors’ IRR, and the easiest approach to calculating this is by using a financial model.

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