Private Equity.docx

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1. Vorlesung – IntroductionVenture Capital (VC)financial capital provided in early stage of the company

Leveraged buyouts (LBO)when asset/firm is bought with a significant amount of borrowed money, so that the CF of the purchase is used to repay the borrowed money.

Private Equity Fundsinvestment organization focusing on high-risk projects with a high reward

Private Equity Nicheno debt as there are no promised payments, not public as there are no withdrawals

Structure of private Equity Firmslimited partners: contribute capital but not in management. Have only limited

liability to their capital. Investor. No participation in investment policy or portfolio companies

general partner: unlimited liability and runs operations. Manages funds and invests money. Builds up a portfolio of companies that should invest in. Treuhändler = fiduciary

Main Characteristics of private Equity1. Illiquidity: if a firm is private it cannot sell stakes to get money. Therefore the

investors want to have influence in running the firm. 2. Uncertainty and asymmetric information: without a market price, which is a

stake, it is hard to value a firm and measure its performance, therefore it moral-hazard is possible

3. Cyclicality: all elements in PE are cyclical: fund raising, sales, IPO´s (Initial Public Offering: shares are sold to institutional investors who then sell it to the public. Through this a company becomes a public company)

4. Certification: in a repeated game with information problems it is very important to have a good reputation

5. Incentives: Where illiquidity is possible deals have to be carefully coordinated6. Deal Context: The context of such a deal matters. Private Equity investments

are managed therefore the investors matter and what type of investor it is7. Human Capital: provides career opportunities

Instances of PE 1. Angel Investing: individual invests capital < 1Mio2. Venture Capital: investment fund, organized as limited partners Equity stakes

are going to an entrepreneurial firm. ᴓ8Mio3. Growth Capital: capital injection to fund a risky project for which no debt can

be raised ᴓ2Mio investors get equity stakes4. LBO (Leverages Buyout): Investor purchases the majority of the companyProperties of private equity transactions 1. Illiquid Assets: No market for privately held shares. PE stakes are often sold to

another PE Fund but it can take years to turn the stake into money2. Long-term relationships: beyond 1. PE stakes are not sold quickly even when

investment goes good.VC investments 5-7 years, LBO 9 years3. Active governance: PE investor is not only an investor but is also active in

running the firm smart money –> PE investor can have connections and

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know-how4. Deal sourcing: PE managers find investment opportunities and are searching

for investors to get the target amount 1 year, then deal is negotiatedInvestorsEndowments: pool of money supporting unis or foundations. Long time horizon. Pension fund: long time horizon but very stable flow. Corporations: either purchase or searching for new developments. As they are

taxable, timing is very important. Sovereign wealth fund: state owned funds investing in financial assets (Abu

Dhabi etc.). Long time horizonFunds of funds: agent(intermediary) allowing small PE investors to invest

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2. Vorlesung - Fund Raising (The limited Partnership)

1.Limited Partnership Agreement

1.1 Timeline of a PE Fund

1.2 Legal Organisation Limited partnership is the standard organisational form, bc it is flexible and

has legal benefits. flexibility is very important as PE funds cannot be planned out in advance Private placement memorandum (PPM):

private offering to a small number of investors. like a very detailed and accurate contract, defining the conditions of the investments, but unclear about:

- which investment - who the other LP´s are

- when the money is invested compared to a mutual fund manager: investors know where the money will

go. GP is the manager of the fund but it is very hard to control which makes

incentives necessary

1.3 Agency Problems in the General Partner and Limited Partner relationship

LP´s want measure to guard their investments GP´s are legally bounded by fiduciary duty (Treuhand) to act in the interest

of LP BUT very hard to verify. Lawsuits are expensive and inefficient —> ensure alignment of interests with three measures:

LPAC (Limited partner advisory committee): important decisions have to be approved

LPA (Limited partnership agreement) profit split

1.4 Limited Partnership Agreement defines major characteristics of the fund duration costs and fees, profit calculation and profit splits restriction

1.5 Characteristics of the fund minimum and maximum size of fund contribution of LP`s (sidepocket funds: contributions of GP (usually 1%)

life time limits:Venture Capital (VC (Riskokapital)): 10years + 2 optional 1 year extensionsLimited Buy Outs (LBO): 7years + extensions —> can be pushed for growth strategies, defines what happens under extreme

circumstances how fund is dissolved unter extreme circumstances

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1.6 Management of the fund Covenants (specification in contracts) specify: concentration limits:

percentage that can be invested into one company bc diversification and risk-shifting

1 debt limits:not allowing risk increase through debtinvestors cannot borrow or guarantee debtif it is allowed only possible for a specific percentage of

committed capital

1.7 Activities of the General Partnercovenants restricting the activities of a GPInvestment of personal funds

no cherry picking to not disturb portfolio balanceSale of partnership Interest

sale of partnership in the LPA. Future Fund Raising

risk that GP loses track of current funds if raising money for a future fund, therefore not allowed until a date or a % that is already invested

Time InvestmentGP are required to invest all their time into that fund

New GPif GP is new, needs resources for training but needs LPAC approval.

1.8 Types of investmentsinvestment is not known, but LP´s want to restrict the possibilitieslarge fees are not accepted if investment is not active enoughGP have to orient themselves in one asset class (group of securities with similar

characteristics) even though they might be also interested in new areas.

1.9 Time Variation in strength of covenantscovenants are used to align incentives between GP and LPrepresenting the bargaining power by how much one partner is less powerfulover time bargaining power can shift when e.g. venture capital firms are limited

and partners want to invest, then also the capital flow is faster. a PE firm takes years to build a record, to raise capital etc. when capital flow is faster VC firms can negotiate less covenants and PE higher

fees

2. Payment structures

2.1 The payment structurescovenants can prevent conflicts of interests10 years of managing the funds a strong alignment has to be made to prove that

GP is work hard

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proving that with upside potential (difference btw current trading price and short term earnings)

during fund life time GP is paid with management fees and carried interest (share of profits)

2.2 Management Feesdfees are used to cover salaries, travel costs, rents etc. fees are determined using the raised capital and are like a tax reduced

investment (usually 2% p.a. while established PE firms can charge more and can be reduced during life of fund)

Budget-Based Fees: LPAC and GP determine expensed and afterwards the size of fund is created —>

transparency, usually <2%

2.3 Carried Interestshare of investment gains go to the GP —> usually 20%hurdle rates: minimum rate of return goes first to LP´s and then GP´s. Another hurdle can be

there when the carry increases. usually 20% carry with 8% return to LP hurdle, 25% carry after 15% return

2.4 Distribution of carried interestdistributed at time of exit, PE is not reinvesting until the current fund has endeddistribution of gains:whole of funds: when LP´s full investment is repaid then LP and GP share the

gains deal by deal: at every exit capital invested by the LPs for that investment are

repaid and carries distributed, the gains are split.BUT: CON: deal by deal increases risk for LP and can decrease the carry %PRO: LP´s can invest again with the distributed money and reduces risk of early

exits.

2.5 Clawbacksdeal-by-deal can lead to an overdistribution to GP when the market for later

investment declines. Clawback is a clause in a LPA which forces GP to compensate the LP

´s when there was over distributionwhen it becomes clear that clawback will hold, GP offer reducing

fees etc. whole of funds

first the investment is returned then the distribution starts —> no clawbacks necessary

BUT: leads to too early exit,when return is reached 2.6 Other FeesVC firms charge carry and management fees, while LBO´s receive add. fees

transaction fees: paid by firms (usually 1 -2% of transaction value), as compensation for the effort put into deals that are almost lost

monitoring fees: add. 1 -5% if EBITDAusually not these fees, but normal management fees are taken

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3. Elements outside the LPA carry split vesting schedule: timing when GP earn the profitDiversification: actual activity of a GP?

3. Vorlesung: Fund Raising / Deal sourcing

o Deal Sourcing2 Primer task is to invest the fund raised3 GP need to:

3.1 Find a deal3.1.1 Difficult even though a lot entre´s need money

3.2 Evaluate the deal3.2.1 Asymmetric information leads to refusing deals that came out good, team

maybe inexperienced, market unknown. In buyouts difficult to evaluate how the staff will react and perform.

3.3 Winning the deal

1. Finding the dealo Specialisation vs. Diversification

PE funds usually specify in an area while mutual-funds try to difersify to reduce risk

More risk for PE, but is balanced out with:o Experienceo Networkso Consistency of investments

Depending on VC fund:o Early stage VC Firms: concentrated in industries and geographyo Corporate VC Firms: concentrated in industry but not geographyo Large VC firms: diversify strong in industry and geography

1.3 Attracting vs. finding dealsAttracting:

High reputation of a PE firm: o They attract deals and are found by investees to invest in sth.

proprietary deals Reputation leads to:

o Self-reinforicing cycle High reputation PE firms, are backed up with high reputation VC

firms who have access to high reputation customers attract higher reputational LP´s

Other PE firms need to find deals.

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1.4. Proprietary dealsInvestors reach investor

Time advantage High expertise with VC and therefore in depth evaluation and better

collaboration For buyouts important:

o Auctions can be avoidedo For target: avoiding risk of failed auctiono Avoiding spreading of information; qualified buyers receive memorandum

(Confidential information memorandum CIM)

1.5 Active deal sourcing1. GP`s develop a road map looking for good opportunities in their area of

expertise and looking for potential investors2. Contacts start mostly personally or through intermediaries

a. Friendsb. Commercial bankers: providing loansc. Investment bankers: not getting a fee for introduction but a fee

for completed transactiond. Stockbroker: knows who wants to sell a fractione. Service providers: lawyers, come when entre´s need their

service

2. Deal Evaluation

2.1 Deal evaluation Simultaneously evaluating:

o Due diligence: intensive evaluation of a firm to foresee risks o Internal evaluation for approval

Deals are evaluated through 5 dimensions:o Market attractiveness – size, growtho Product differentiation – patentso Managerial capabilities – skills in management, marketing etco Environmental threat resistance – entry barriers, life cycleo Cash out potential – possibilities for mergers

2.2 Due Diligence Business plans change very little, management teams change Overcoming adverse-selection problem:

o High quality entrepreneurs will not enter in a VC to keep everything for themselves, unless they are risk averse and want to split the risk

o Low quality Entre´s will try to get VC funding to share the risk

o VC Firm has to try to separate the two CHECKLIST

o Management Team: Changes can have huge hidden costs but are needed

when the company growth

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Investors will check the team and search for strength and weaknesses

o Customer Checks: When customers are checked and talked to then this

can lead to biased information. Ideally personal contacts are needed in the target

firm

o Sales Pipeline Affected by the pipeline of PE funds Entire sales process relevant

o Financials Start-ups: simple metrics used, s.a. cash needs, sales

etc. Buyouts:

o Product Evaluation Preferably in house evaluation as domain expertise

crucialo Execution Risk

If product badly executed can fail to fill needs Separating technology risks as production

o Legal risk Patents Legal framework might be unclear for innovative

markets Changes in legalisation

2.3 Serial EntrepreneursEntrepreneurs who had multiple successful ventures

1. They build up a track record and higher chances for success2. Success depends ono Timing: right sectoro Managerial skill: regardless of sectoro Support by top VC firm is not increasing success for good entres but is increasing

it for unsuccessful

2.4 Deciding on a deal Process:

o GP finds deal and may search for resourceso GP team meets companyo GP introduces deal informallyo Company formally meets with partnershipo Partnerships approves/declines/requests more informationo GP issues letter of intent(term sheet)o Term sheet is negotiatedo Deal is signed

2.5 Networks and syndicated

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o syndicates share deals while PE´s are very competitive PROs of syndicated VC deals:

1. Expertise is combined2. PR3. Reduced uncertainty4. Ability for larger buyouts5. Might reduce competition

CON´s of syndicated VC deals: Complicates dynamic of team Potential conflicts if investment with different stages

3. Winning the deal

3.1 winning the deal If there is competition within PE funds for a deal it will not go to

the best price Critical how much value the GP can add Not sure how the investor will cooperate under unexpected

circumstances

3.2 Follow-Ons1. Follow ons: Issuing shares after the first offering after IPO2. If milestone met: easier process as GP are involved and monitored3. If milestone are not met: GP team needs new members to ensure objectivity

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4.Vorlesung: Valuation

1. Conceptual Bases of Valuation

1.1 What is value? Price:

Easy concept Characteristic of a transaction Observable

Value:o Abstract concepto Can also be a personal preferenceo St used synonymously with priceo Greater fool theory: buy sth worthless when you expect sb will buy it for a higher

price

1.2 Values and valuation, Objectivity and subjectivity Value of a good is objective Valuation as process to find the value

CF are vague, so there is no unique way to estimate Assumptions necessary to perform valuation

1.3 Valuation and market efficiency- If markets are inefficient:o Buy below value leads to money making- Valuation is necessary wheno No observable market price venture capitalo A change occurs in assets leveraged buyouts

presume market price is right, and when saying under/overvalued then with respect to

1.4 Time value of value- Valuation means finding an expected value conditional on the information- Trying to get the distribution

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1.5 Pre-Money and post-money valuation

Post-money valuation = amount invested/(ownership shares)=Y/yY:investment y:fraction of firm

if investment is not creating value, the firm value increases by the cash gotPre-money valuation = Post-money valuation – investment Y/y -Y

Pre-money valuation is the value if investment were not made if investment is creating value, then the difference between post and pre money

valuation will exceed the investment

Capitalists obtain rights also having a value: o they have convertible ownership and equalizing them with common shares

would:o under-estimate the value of their shareso under-estimate their fractiono over-estimate the value of the firm

2.Revisiting Comparables

2.1. Idea

Idea: similar assets should have similar prices1. identify key variables that are related to value2. identify comparable firms3. for each, calculate multiple key variable which yields to market price of the firm take average over the firms4. apply multiple key variable of the target firm

Pro: o simpleo market-based and forward-looking

Con: no link between key variable and future CF for new technology ventures no comparable firms no information about key variable in target firm

2.2 Comparables for PEValuing PE with comparables:

private-transaction multiples:o pricedata from previous PE transactionso large dataseto beware of timing differences

public multiples:o use multiples from public firmso adjust for illiquidity discount

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2.3 Adjusting for non-diversification public markets: investor holds diversified portfolio if company privately held by undiversified investor, he wants to be

compensated for risk that is potentially above market risk which ß is used depends on investor:

o diversified investor e.g. IPO market ßo undiversified investor depending on diversificationdegree market

ß or total ß

2.4 Adjusting for Illiquidityo discount usually used 25% to 30%o BUT: discount should be firm specific:

Size IPO prospects Financial situation

o Better approach is running a regression and apply equation to a concrete firm bc Discount directly

3. DCF

3.1 Revisiting DCFo Value derived from future CF

Estimate CF over next years CFt Estimate terminal value of remaining CF TVt=CTt (1+g)/(r-g) Find appropriate discount rate:

Identify costs of debt rD Estimate cost of equity via CAPM: re=rf+ß(rm-rf) relever capital structure of target: ßu=ßt E/E+D calculate WACC: r=D/(E+D) x rD x (1-T)+ re x E/E+D

Discount all values to today and sum up:

Pro: o detailed information where value comes fromo less sensitive for irrational enthusiasm

Con:o to find ß need comparable firmso ß insufficient as a risk measure

3.2 Adjusted Present Value (APV)APV is valuing CF from assets as if they were all equity financed. Tax shields and loss provisions are valued separately. Pro:

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o easy to deal with changes in cost of capitalo easy to deal with changes in capital structure

Con:o cannot handle dynamic capital and loss provisions

4. Monte Carlo Simulation 4.1 Definition

o comparative statics/sensitivity analysis looking how much the output changes when one input variable is changed

o scenario analysis setting some inputs and calculates the output

o Monte Carlo Simulation Gives the distribution for all input variables and their dependences. Very easy to calculate Quantifies the relations between variables, and not their value.

5. Venture Capital Method

5.1 Definitiono For start ups following values are important:

Current negative CF No earnings Potential to change

5.2 Applying the VC Method1. VC value Company in several years time when successfully changed to positive

earnings and CF also valuing the exit, usually time shorty after IPO

2. coming up with a target rate of return Usually computed with intuition and high with 40% to 75%

3. Discount the terminal value with the target rate by today

4. relate discounted terminal value to planned investment to determine how much of the company to get

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5. adjust required ownership shares by retention ratio

5.3 Pro´s and Con´sPro:

o easy valuation and focuses negotiation on the target rateo industry standard

Con:o target rate set without reasonable argumentso hides value drivers

5.4 Value driverso using DCF gives a structural valuation (multiples)o highly sensitive for the valuation are revenue of growth and sust. Operating

margins

6. Real-Options Approach

6.1 Definitiono financial options: right to buy a stock in future for a fixed price (calc. with black-

scholes formula)o the same for real assets (real option) with option to:

increase/decrease production build new plant enter new or leave market

6.2 Value of Real Optiono Value depends on

Price to exercise option Underlying price: the value of project Time to expiration: time when option becomes worthless Risk free rate Standard deviation of returns of underlying price

6.3 Pro´s and Con´so Pro:

Decisions are transparent and values them Ideal for scenario trees

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o Con: Hard to get good estimates for all input parameters

5. Vorlesung – Deal Structuring

1. Securities

1.1 common stocko Public companies raise equity trough common stockso Common stocks/shares: fractional ownership of a company

Common shareholder have no special rights (1vote per share in general meeting) and receive ownership after more senior shareholder are paid full after:

Taxes/duties Employee claims Trade debts Bank debts

1.2 Private Equity and common stockso VC investors are not relying common stocks because:

Usually having only a minority share As there is no public market yet they cannot sell the shares if the company

acts against their interest which leads to illiquidityo Problem is severe

Strong asymmetric information and therefore moral hazard

1.3 Security choice for PE investmentso Guarding against not aligned interest with pay-for-performance principle where

equity should be earned through value creation Preferred stocks

o If Max had invested the 1.5m in preferred stocks instead of common stocks, the preferred stocks have to be paid first and have a face value such that Max would have gotten his 1.5m investment back instead of losing 500t.

Vesting owners shareso Managers stocks are not his own until a specified time passed. Max

would have owned 100% of the shares and Sam could not have selled it.

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Covenants and super majority provisiono Selling a specified amount of shares is forbidden without the approval

of the investors. separation of ownership and control

1.4 Redeemable Preferred Stock (straight preferred)o Cannot be converted into common equity. o Fixed amount is paid back after other fixed claims are paid back. There is no fixed

maturity but it has a maturity (earlier the IPO or 5-8yrs). o E.g. Max has investest 1.5m into redeemable preferred stocks. Stocks have face

value of 1.5m and max gets his money back. When selled for 2m Max would get 1,5m and 500t would split into the ownership percentage.

o No catch-up phase for the entrepreneur mix of preferred and common stock

1.5 pricing common stock along with redeemable preferredo Downside protection: When the investor has a high fraction of preferred stocks then the entrepreneur

will ensure that the gains overcome the investments so that he has personal gains aligned investments

o Cheap common stock: Hold by employees which aligns incentiveso Tax deferral: Redeemable preferred stocks are no gain as it is only paying back money, so no

taxes occur. Taxes occur when common stock is sold.

1.6 Drawbacks of redeemable preferredo Slow catch-up phase for the entrepreneur lead to difficulties with negotiationo Redeemed is repaid slightly before an IPO money from IPO will be used to

repay the old investors, and can make the IPO difficult SOLUTION: convertible preferred stock

1.7 convertible preferred stock to common stocko If e.g. the company gets liquidated and the value is higher than the value of the

preferred stocks, than the investor will convert the PS into common stocks to get a fraction of the gain.

1.8 participating convertible preferred stocko Convertible preferred stock with additional right to participate in gains if not

convertedo Equivalent to common equity with preferential claim on the face valueo Acts like redeemable preferred stock while firm is private and after IPO converts

into common stocko No catch up phase for entrepreneurs

1.9 Multiple liquidation preferenceo Multiple amount of invested capital needs to be paid first

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o 2x preference: twice the amount invested needs to be returned after that entrepreneur gets the gains

o catch up possible

2. Exotic securities (Gingerbread)o combining different securities

2.1 Seniorityo securities have senioritieso senior: the payoff of a higher seniority needs to be done before a lower seniority o seniorities with the same level are paid pooled

2. Terms of purchase agreement To avoid potential conflicts of interest

2.1 Vestingo Acquisition of ownership over timeo Long term perspective for managers and ties hem to the company o For an employee it is an incentive to stay (golden handcuffs)o Acceleration of vesting: percentage which becomes vested

2.2 Covenantscontractual agreements between investor and firm

o Two types of covenants: Positive covenants:

o Require certain actions of the managero Provisiono Reporting

Negative covenants:o Disallow actionso Stock saleso Asset saleso Major financing decisions

Mandatory redemption provisionso Allowing investors to put preferred stocks back into company o Increases bargaining power of investors who do not want to liquidate firm

Registration rightso Holder can demand to register the share for public trading

Piggyback rightso Holder can sell shares into anything public which the company already

undertakes

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8. Vorlesung – Deal Management and Governance

1. The boardSource of all setup that ensures that firm is working how it should1. The board

o Board has investors, management and outside directorso Term sheet states voting power and exceptions etco Board members have a fiduciary duty to shareholders

2. Board member activities o Usual VC manager is sitting in 5 boards and is monitoring 9 portfolioso Main tasks in order:

1. Raise additional financing2. Strategic planning3. Recruitment management4. Operational planning5. Introduction to suppliers and clients6. Resolving compensation issues7. Serving as CEO

3. Value creation o Value creation start with deal evaluationo For LBO´s the first decision is to decide whether management should run it

furthero Sources (external):

General market and specific sector conditions Deal-making ability Risk arbitrage when firm mispriced

o Sources (internal): Multiple expansion

o firms are valued with multiples which depends on characteristics of firmo while firms develops the characteristics can change

Operative performance

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o Main point to become efficient and growo When LBO: cutting costs, reduce/increase scale and scope to an optimal levelo When VC: building a product, bring it to the market, increase market shareo Both: focus on core competencies and outsource tasks outside

Capital structureo Working on the financial side o Minimizing requirement for working capitalo Optimization trough e.g. leasing

2. External Growth M&Ao Fastest way to grow is to merge and acquisitionso Motifs for acquisitions:

o Economies of scaleo Diversificationo Synergies

3. Staging of Financing

o LBO´s have long term financing through the dealo Refinancing only happens if firm has distress

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9. Vorlesung – Exit decision

9.1. Exit Time1. optimal to exit when the benefit of the value is bigger than the costs to spent more time into the portfolio. 2. when the outside opportunity is bigger than the gain.

9.2 Exit Methods1. Acquisitions (Mergers & Acquisitions; M&A)

Selling company to another investor most common If the new investor buys it for strategic reasons it is called: trade sale If another PE firm buys it: secondary buy-out IPO´s are st used to increase the price of the acquisition. After the IPO potential

buyers are more informed and confident to buy and can raise the competition. IPo`s are normally used for non-debt financing of a good working company, while acquisition is more about a company who is highly levered and investors want immediate illiquidity.

Difference between merger and acquisitiono Acquisition: management can stay but board doesn’t longer exists.o Mergers: stock for stock trade. Board has directors of each company.

1.1 Trade sales (approc 4-6 months) Find an acquirer Compared to an IPO the trade sale is

o Not so regulatedo Not dependent on market conditionso Cheaper

Procedure: Bank

o Investment bank pre values the firm

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o Makes a list of potential buyerso Produces the memorandum ( bank book or CIM (confidential information

memorandum) Iterative Procedure

o High level information is distributedo Interested buyers sign an agreement and get the CIMo Initial non-binding bit and signing a letter of intent (LOI)o Some bidders then get into the data room, where binding bits are given

Signalling via CVC (Corporate venture capital)o Credible information and signalling can increase the returnso Venture capital investors gain knowledge already and it is very possible

that it will bid for the firm. 1.2 Secondary buy outs New investors are familiar with the business and procedure LP´s usually critical because

o if invested in both firms, the new transaction didn´t increased their gaino the first PE firm did not improvedo investors for the second fund are paying twice the fee, to the old investors

and to the new ones

2. IPO Prime way to exit, but not an exit more an opportunity

3. Buy-Backs4. Liquidation

Can be in the interest of investor to liquidate soon, when other opportunities are generating more value (active investing) interests are not aligned anymore

LBO´s are usually done after failed negotiation5. Partial/delayed exits

5.1 Dividends (Partial Exits) Can be seen as partial exits as money goes back to the investor Bigger dividends are paid when firm has repaid some debt

5.2 Private to private M&A (delayed exits) Share Deal:

o When merged the investors get again non-liquid stock of the merged company

o Often acquiring firms that are not failing but also not succeed loss minimizing strategy

Asset Sale:o Assets are sold (patents) and company shell is shutted down

9.3 Distribution of proceeds PE fund gets the proceeds (cash or stock) and distributes them to the LP´s If proceeds in cash: usually distributed immediately in cash -´´- in shares: lock up period when shares cannot be sold Advantages of distributing stocks:

o SEC regulation: Size restrictions when selling

o Tax consideration: Capital gains are taxed

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o Performance measurement

10. Vorlesung – Performance Measurement

10.1 Typical Measures Cash on cash returns

o CoC= Sum(money distributed to LP) /Sum(paid in capital)o CoC (during lifetime)= Sum(money returned) + current valued of funds

/Sum(paid in capital)o If < 1 fund has lost money o BUT: ignores the time value of money, therefore calculating the IRR

Internal rate of return (IRR)o 0 = Sum(CFt(1+IRR)^-t -> IRR and NPV, when disagree NPV is righto BUT; IRR favourises early repayment difficult for PE where investment

over years is not repayed

10.2 Meaningful measures NPV

o Better than IRR to compare Public market equivalent (PME)

o Benchmark the investment against the marketo Relates the sum of distributions to the sum of investments, while both are

related to the public index at that date

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o PME <1 market realized higher returnso PME >1fund has generated more value than the investment would have

gained in the public marketo BUT: doesn’t account for risk, illiqiuidity

Asset Pricing Theory (APT)o Individual return = sum of risk compensations plus a constanto High beta more risko Alpha implies also management skills making it higher when managers

are good (performance)o Rt = a + Sum(Bi*rt) + eto Stale price: last observed price, s.t. regression has missing values. If too

many are missing regression is not goodo Mark to market: market value of pf determined as often as possible

10.3 Diversification Asset Allocation

o Only a diversified pf is efficient and a mix of various assets needs to be determined

Across vintageso Vintage is the year the PE fund it set upo Capital is illiquidit for years

Across classeso Classes of different characteristics and different return opportunities

Across regionso Diversifying over geographic areas, being diversified over economic

conditions Across industries

o PE funds often highly specialized

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11. Vorlesung – Growth and cycles

11.1 GrowthGrowth of PE fund only by raising more funds

Dispersion (distribution)o Differences in funds and their performance

Persistance (patience)o The performance of the last fund has an impact on the performance of the

next fund. When the fund previously outperformed it is likely (48% while staying the same means 33%)

Maturity (due date)o First time funds usually underperform, while in time they perform better.

Reasons can be that: greater experience and therefore better judgement. Or Darwinian effect where improvement is because ineffective groups do not survive.

Sizeo When capital is expanded too quickly the returns decrease. Peak

performance at 300m$. o But different peaks for Buyouts and for VC. For VC inverted U is true and

peak is at 280m$, while buyouts are flatter with a peak at 1.2b$ Changes in size

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o With increased fund size the internal rate of return decreases not because of the fund at the beginning

o Investment per investor increases as fund size grows faster than number of investors

11.2 Cycles Funds raised

o High stock prices are a sign for a hot IPO phaseo LP´s rate of investment:

Pro-cyclical: hot periods lead to large CF and LP will invest moreo Herding:

Investors will concentrate on hot sectorso Capitalising reputation:

Good reputation leads to easier acquired funds and more capital Investments

o Debt level Is important for LBO´s Performance of investments

o Investments at market peak seem to underperform o High leverage makes firm vulnerable

Dealing with cycleso