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Real Options in Private Equity Firms

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Real Options in Private Equity Firms LUT University School of Business and Management Strategic Finance and Business Analytics REAL OPTIONS IN PRIVATE EQUITY FIRMS Master’s thesis 24.10.2019 Teemu Karuluoto Supervisor/Examiner 1: Professor Mikael Collan Examiner 2: Postdoctoral researcher Azzurra Morreale ABSTRACT Author: Teemu Karuluoto Student number: 0421035 Title: Real Options in Private Equity Firms Faculty: LUT School of Business and Management Degree program: Strategic Finance and Business Analytics Professor Mikael Collan Examiners: Postdoctoral researcher Azzurra Morreale Keywords: Real options, Private Equity, Private Equity firms, Private Equity funds Real options existing in private equity firms have not been extensively studied previously. The objective of this study is to provide opening research on the subject as only a few relevant studies have been made before. The aim is to recognize different real options that private equity firms have in their organizations, funds, and their portfolio companies. In addition to recognizing these real options, the value of these real options is discussed. Also, this research discusses how real options are used in private equity firms in practice. Broad introductions to both real options and private equity are presented to understand how real options work and what types of them may exist in private equity firms. The research process of finding and recognizing real options in private equity firms is based on the state-of-the-art literature review that further proved the gap in the academic literature for this subject. Five interviews provided an empirical viewpoint for the study. In the interviews the practical use of real options, existence of previously recognized real options, and new real options existing in private equity firms were discussed and found. The findings of this research suggest that the use of real options seem not to be used in practice in private equity firms. Even when talking about things related to real options, the actual term is not often used. In this study, a total of 29 different real options were recognized, of which 18 were not previously found in the academic literature. Lastly, the demonstrative examples show that these real options are valuable for private equity firms. TIIVISTELMÄ Tekijä: Teemu Karuluoto Opiskelijanumero: 0421035 Tutkielman nimi: Reaalioptiot pääomasijoitusyhtiöissä Akateeminen yksikkö: LUT School of Business and Management Koulutusohjelma: Strategic Finance and Business Analytics Professori Mikael Collan Tarkastajat: Tutkijatohtori Azzurra Morreale Reaalioptioita pääomasijoitusyhtiöissä ei ole aiemmin laajasti tutkittu. Tämän tutkimuksen tarkoituksena on toimia tutkimuskentän avaavana tutkimuksena, koska vain muutamia relevantteja tutkimuksia tästä aiheesta on tehty aiemmin. Tavoitteena on tunnistaa pääomasijoitusyhtiöiden organisaatiossa, rahastoissa ja heidän portfolion yhtiöissä olevia reaalioptioita. Näiden reaalioptioiden tunnistamisen lisäksi myös niiden arvot käsitellään ja keskustellaan. Tämä tutkimus myös käsittelee kuinka reaalioptioita käytetään pääomasijoitusyhtiöissä käytännössä. Laajat esittelyt molempiin aiheisiin, reaalioptioihin ja pääomasijoitusyhtiöihin, käydään lävitse, jotta ymmärretään kuinka reaalioptiot toimivat ja millaisia niitä voi löytyä pääomasijoitusyhtiöistä. Tutkimus reaalioptioiden löytämiseksi ja tunnistamiseksi pääomasijoitusyhtiöissä uusimpaan ja perusteelliseen kirjallisuuskatsaukseen aihepiiristä, mikä entisestään todistaa aukon akateemisessa kirjallisuudessa tälle tutkimukselle. Empiirisen näkökulman tutkimukselle antoi viisi eri haastattelua. Haastatteluissa keskusteliin reaalioptioiden käytöstä käytännössä, aiemmin löydettyjen reaalioptioiden olemassaolosta ja uusien reaalioptioiden löytämisestä pääomasijoitusyhtiöissä. Tutkimuksen tulokset osoittavat, että reaalioptioita ei juuri käytännössä käytetä pääomasijoitusyhtiöissä. Vaikka reaalioptioihin liittyvistä asioista puhutaan, niin itse termiä ei usein käytetä. Tässä tutkimuksessa löydettiin yhteensä 29 erilaista reaalioptioita, joista 18 ei oltu aiemmin akateemisessa kirjallisuudessa löydettyjä. Lopuksi havainnolliset esimerkit näyttävät, että näillä reaalioptioilla on arvoa pääomasijoitusyhtiöille. ACKNOWLEDGMENTS Writing this thesis was certainly not the easiest task, but it certainly has been a rewarding learning experience for me. I want to thank my thesis supervisor Mikael Collan for encouraging me to take this challenge of writing a thesis about something that had not been extensively studied by the academic literature before. I also want to thank him for letting me take me time and space to do the research and writing this thesis very independently. Finding time to write this thesis at the same time while running my own companies and being part of a few different projects has been far from easy. However, I am glad I managed to write this at the same time as working and living the family life. Also, I would like to thank all the interviewees of this research; Tero Luoma, Vesa Uotila, Heikki Westerlund, Sakari Pihlava, and Juha Peltola. In addition to these interviews being a crucial part of this research, they taught me personally a lot about the private equity industry and its practices. Thank you very much for your time and patience in the interviews. I hope these interviews and this research may have given you some food for thought. Besides the interviewees, I would like to thank all the people who brainstormed with me about the subject of this research. Special thanks to my godmother Päivi for helping me to prepare for the interviews. Now that my university studies at LUT are coming to an end, I have to appreciate the whole student experience. I must say I have been lucky to be able to make a lot of new great friends in LUT and other universities in Finland, and for this, I especially have to thank our student association Enklaavi and the board 2016 that I was able to be part of. Furthermore, a big thanks to my family. Thank you, dad, for guiding me towards ambitious goals in my life. Thank you, mom, for always being there for me in good and bad situations. Lastly, I want to thank my fiancée Janina for all the support throughout the studies. Thank you also for taking care of our sons Oliver and the newly born Leo while I have been running like the wind from one place to another. Teemu Karuluoto TABLE OF CONTENTS 1 INTRODUCTION .............................................................................................................................. 9 1.1 RESEARCH BACKGROUND .......................................................................................................................... 10 1.2 OBJECTIVES AND RESEARCH PROBLEM ......................................................................................................... 12 1.3 RESEARCH METHODS ............................................................................................................................... 14 1.4 STRUCTURE OF THE STUDY ........................................................................................................................ 16 2 REAL OPTIONS ............................................................................................................................. 18 2.1 OPTION VARIATIONS ................................................................................................................................ 21 2.2 DIFFERENT TYPES OF REAL OPTIONS ............................................................................................................ 22 2.2.1 Option to Defer .......................................................................................................................... 23 2.2.2 Staged Investment option .......................................................................................................... 25 2.2.3 Option to Alter ........................................................................................................................... 27 2.2.4 Option to Abandon .................................................................................................................... 29 2.2.5 Option to Switch ........................................................................................................................ 31 2.2.6 Growth Option ........................................................................................................................... 32 2.2.7 Multiple interacting options ...................................................................................................... 34 2.2.8 Learning option .......................................................................................................................... 35 2.3 REAL OPTION REASONING ........................................................................................................................ 37 2.4 REAL OPTION VALUATION ........................................................................................................................ 40 2.5 REAL OPTION APPLICATIONS ...................................................................................................................... 41 2.6 ISSUES WITH USING REAL OPTIONS ............................................................................................................. 44 3 PRIVATE EQUITY .......................................................................................................................... 45 3.1 PRIVATE EQUITY DEFINITION ....................................................................................................................
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