W1 Private equity demystified ch 1

[Audio] Private Equity Demystified: An explanatory guide. Fourth Edition. John Gilligan and Mike Wright, Oxford University Press (2020). © John Gilligan & Mike Wright. DOI: 10.1093/oso/9780198866961.003.0001 1 The Private Equity Market In this chapter we set the scene: we clarify some definitions, describe the origins of the private equity market, and examine the data on the size and growth of the private equity industry. What is Private Equity? 'Private' Private equity (PE) is risk capital provided outside the public markets. It is worth emphasizing at this early stage that the word 'private' has nothing to do with secrecy. It simply contrasts with the 'public' quoted markets. Public markets offer shares to institutions and individuals and are accordingly regulated. Private transactions are not unregulated, but they are regulated differently. The idea is that public markets provide protections appropriate to individuals whereas the regulation of private markets is appropriate to the parties to those transactions, who are usually, but not always, sophisticated institutions and high net worth individuals. 'Equity' Equity is the umbrella term under which you find an array of financial instruments that equitably share in the profits and losses of a business. Traditionally equity has been defined as a residual claim on the profits and assets of a business after all other claims have been settled. It has usually been seen as being synonymous with 'ordinary shares' or 'common stock'. It is still the convention to refer to an equity percentage meaning the percentage of ordinary shares or common stock held. However, as we will expand upon, equity has a broader meaning when used in the phrase 'private equity'. It means the total amount of capital that is both put at risk of loss in a transaction and that, as a financial package, has a share in any capital gain earned. As we shall elaborate in Chapters 5 and 6, a private equity investment will often be in the form of both ordinary shares and loans and may well include a variety of exotic financial instruments. The key idea to focus on is that the 'equity' in private equity is a package of financial instruments..

[Audio] 2 Private Equity Demystified What Is the Difference between Venture Capital, Growth Capital, and Private Equity? The businesses invested in by private equity range from early-stage ventures, usually termed venture capital investments, through businesses requiring growth or development capital to the purchase of an established business in a management buyout or buy-in. In this sense private equity is a generic term that incorporates venture, growth, and buyout capital (see Figure 1.1). However, while all of these cases involve private equity, the term is now often used to refer to both later-stage development capital and, predominantly, buyouts of established businesses. These are generally the focus of our commentary, although we will also comment on the resurgent growth capital sector when relevant. Private equity usually contrasts with Venture Capital which is used to describe early-stage investments. The term therefore has a confusingly loose definition, being both a generic term for 'not quoted equity' and a more precise definition referring specifically to the market for institutional private equity funds that target buyouts and growth capital. Care is needed to be clear which definition is being used when discussing or researching private equity. Each of these categories is known as an 'investment strategy'. Buyouts constitute the largest of the investment strategies by value. They account for the majority of primary deal value and, when secondary strategies are included, they represent some 40 per cent of the private equity market value (Figure 1.2). The evolution of the term is perhaps best illustrated by the naming of the various trade bodies: the British Private Equity and Venture Capital Association (originally, the British Venture Capital Association), BVCA, is the UK trade association; EVCA, which is the European trade body, renamed itself 'Invest Europe' in 2015. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Time in years Revenue/ Cash Sm Venture Capital Growth Capital LBOs Turnaround/ Distressed Debt 17 18 Private Debt Profits Sales Figure 1.1. Investment strategies and the life cycle of the firm.

[Audio] The Private Equity Market 3 What Do Private Equity Fund Managers Do? Private equity fund managers have five principal roles. Realise Value from Investments Build & Activity Manage a Portfolio of Investments Negotiate & Structure Deals Raise Funds Source Investments Raise Funds from Investors These funds are used to make investments, principally in businesses which are, or will become, private companies. Funds are raised from investors, often internationally, such as AGGREGATED CAPITAL RAISED IN 2018 BY FUND STRATEGY Venture Capital 15% Turnaround 0% PE Secondaries 3% PE Fund of Funds 4% Other 24% Growth 12% Buyout 42% Figure 1.2. Relative size of different private equity investment strategies Source: Preqin.

[Audio] 4 Private Equity Demystified pension funds, insurance funds, foundations, family offices, banks, and insurance companies. There are collective ways for individuals to invest in private equity in some countries, but generally most money comes from institutions. These investors will generally invest via a limited partnership, as will the private equity fund managers themselves. In Chapter 2 we expand on the fund management roles of private equity. Increasingly, as discussed later, some large fund managers are becoming multi-asset managers with contracts to manage a variety of fund types including, but not exclusively, private equity. Source Investment Opportunities A private equity fund must source and complete successful transactions to generate profit and support the raising of further funds. A significant amount of effort and resource is invested in prospecting for transactions and relationship management with individuals who may give access to deals. In addition to potential investee companies, these relationships include investment bankers, lawyers, accountants, and other advisers and senior figures in industry. Increasingly, investment teams are focusing on particular sectors of the economy. Historically most funds were geographically constrained to their local market. Today we see global private equity funds. The holy grail of private equity is to have a strong source of so-called proprietary deal flow. This is a rich seam of transactions that can be completed without a competitive process being run on behalf of the vendor. An increasing amount of effort is going into direct targeting of businesses, meeting them ahead of any potential transaction to build knowledge and relationships and, potentially, investments outside of full-blown intermediary-led processes. Negotiate, Structure, and Make Investments Having found investment opportunities, private equity fund managers have to negotiate the acquisition and structure the finances of the transaction to achieve the multiple objectives of the various parties. Fund managers therefore need skilled financial engineers and negotiators in their team to create the desired blend of incentives and returns while managing the associated risks. In the early days of private equity, fund managers were usually financial experts rather than sector or operational management specialists. This has changed over the years. It is argued by advocates of private equity that this trend has contributed to the development of more effective management techniques within its investments. In Chapter 5 we explain the basics of deal structuring and we provide a worked illustration in Chapter 6. Private equity uses third-party debt to amplify investment returns (see Chapter 2). Fund managers therefore need to be skilled in creating financial packages that generate the required blend of incentives without creating excessive risk. Actively Manage a Portfolio of Investments Private equity fund managers have become hands-on managers of their investments. While they do not generally exercise day-to-day control, they are actively involved in selecting management teams and setting and monitoring the implementation of strategy..

[Audio] The Private Equity Market 5 This is the basis of the argument that private equity has become an alternative model of corporate governance. The growth in the operating partner groups who focus purely on the performance of portfolio companies is indicative of the growing importance of active management of PE investments. Realize Returns Fund managers realize returns primarily through capital gains by selling or floating private equity investments, but also from income and dividend recapitalizations, which we examine in Chapter 3. The vast majority of PE exits are to trade buyers or other PE funds. The industry generally now talks of a four- to six-year exit horizon, meaning that the investment will be made with the explicit assumption that it will be sold or floated within that timeframe. This exit horizon is the source of the criticism that private equity is a short-term investment strategy. Private equity managers often work out their likely exit routes before they make any investment. There are pressures to vary the length of fund lives, either shortening (by providing liquidity in the secondary market) or extending the life of the fund. These create new issues that we discuss in Chapter 3. Much of the change in private equity investment over the past few years has been in fund management strategies, both by PE fund managers and by their investors. What Is a Private Equity Fund? Much, but not all, of the investing done in the private equity market is by private equity funds. A PE fund is a form of 'investment club' in which the principal investors are institutional investors such as pension funds, investment funds, endowment funds, insurance companies, banks, family offices, high net worth individuals, or funds of funds, as well as the private equity fund managers themselves. The objective of a PE fund is to invest equity or risk capital in a portfolio of private companies which are identified and researched by the PE fund managers. Private equity funds are generally designed to generate capital profits from the sale of investments rather than income from dividends, fees, and interest payments, although this has changed over the years as new forms of PE vehicles have emerged. We discuss this further in Chapter 2. A Private equity fund may take minority or majority stakes in its investments, though generally it will be the latter in the larger buyouts. At the same time that a Private equity fund makes an investment in a private company, there is usually some bank debt or other debt capital raised to meet part of the capital required to fund the acquisition. This debt is the 'leverage' of a leveraged buyout. What Are the Objectives of Private Equity Investment? An alternative definition views private equity as institutional investors who buy businesses with the explicit intention of selling them when the business is acquired.1 This definition 1 Jeremy Coller, founder of Coller Capital, 2019..

[Audio] 6 Private Equity Demystified provides a useful way of thinking of the industry and has the advantage of capturing all types of fund structures. Obviously, all purely financial investors wish to make a return. This can be either an income, from fees, interest, or dividends, or a capital gain by selling a particular investment when it has become more valuable. Private equity is predominantly about generating capital gains. The idea is to buy equity stakes in businesses, actively managing those businesses and then realizing the value created by selling or floating the whole business on a public market. The appetite and incentives of most private equity investors are firmly focused on achieving capital gains. They generally aim to achieve capital growth, not income. The objective of private equity is therefore clearly focused on increasing shareholder value. This contrasts with other investors who buy businesses aiming to own them forever and generate their return by taking out cash in dividends. Are There Any Theoretical Ideas behind the Private Equity Investment Model? Private equity has been widely studied for many years. If you went to Google Scholar and typed in 'private equity' you would find around 215,000 references, of which about 20,000 were added in the last two years. Volume is no measure of quality, but it does point to interest. A Google Ngram search on the same term shows the rising levels of interest in books in English since the term emerged in the late 1980s (Figure 1.3). The Paradox of Private Equity Performance Historically the returns in private equity have been consistently reported as being higher than those in public markets. The assertion of outperformance is itself controversial, but it is certainly true that outperformance is widely claimed and demonstrated, using a variety of methods. Some of these methods are disingenuous, some questionable, but the data are consistent, if surprising. We discuss this in Chapter 3. 1970 0.000000000% 0.000000050% 0.000000100% 0.000000150% 0.000000200% 0.000000250% 0.000000300% 0.000000350% 1975 1980 1985 1990 1995 2000 2005 2010 2015 "private equity" Figure 1.3. Google Ngram on 'private equity', 1970–2010 Source: Google Downloaded from https://academic.oup.com/book/31976/chapter/267724321 by King's College London user on 22 October 2023.

[Audio] The Private Equity Market 7 A second surprising thing about private equity is that this outperformance is found in funds that are highly active in the mergers and acquisitions (M&A) market. The majority of academic evidence, with some recent exceptions, has shown that businesses that are active in the M&A market destroy shareholder value. How is it then, that PE funds, whose core competence is in M&A, seem able to buck that trend? Furthermore, most private equity funds are buying control of a business in a competitive auction, and the evidence on auctions is again clear: there is usually a 'winner's curse' in any competitive auction because the most optimistic bidder with funds, always wins.2 There have been a number of arguments put forward to explain the apparent success of the private equity model of investing. Seekers of Market Failure The first and simplest is that private equity seeks out and takes advantage of market failures that create mispricing opportunities. This argument encompasses both a trading strategy, taking advantage of periodic mispricing, and an active search for financial gain by taking advantage of so-called 'loopholes'. One particular version of this argument that is widely discussed is the question of what impact the tax deductibility of interest has on investment returns. It is worth saying at this early stage that not all interest is deductible against tax and that there are no special exemptions for private equity of any kind. On the contrary, there are in many countries special provisions designed to disallow the deductibility of interest on connected party loans of the type used by PE firms. We revisit the critics' version of this argument in more detail below. Solving the Principal–Agent Problem The second and more widely accepted economic theory in the academic literature argues that there is a principal–agent problem in many companies.3 The shareholders are the principals (i.e. owners) of any corporation. Managers act as agents of shareholders. Managers are incentivized by whatever their employment contracts motivate. They are not generally incentivized to maximize the realizable value to the shareholders. Furthermore, there is no clear way to hold management to account for their actions. In consequence shareholders do not try to hold managers to account. If they do not believe the managers are maximizing value, in publicly traded companies, investors simply sell the shares and move on. Shareholders in private companies that are managed by agents on their behalf will, under this hypothesis, receive lower returns than they otherwise might have received. It is argued that this lack of accountability of senior managers allows them to pursue projects that are either excessively risky or, conversely, excessively conservative. This represents an inefficiency of the market. 2 Richard H. Thaler (1988), 'Anomalies: The winner's curse', Journal of Economic Perspectives 2(1): 191–202. 3 Michael C. Jensen and William H. Meckling (October 1976), 'Theory of the firm: Managerial behavior, agency costs and ownership structure', Journal of Financial Economics 3(4): 305–60. Downloaded from https://academic.oup.com/book/31976/chapter/267724321 by King's College London user on 22 October 2023.

[Audio] 8 Private Equity Demystified Private equity seeks to address this principal–agent problem by tightly aligning the interests of managers and shareholders to achieve economic efficiencies over a defined time period. This idea of alignment is central to all the economic structures observed in the private equity market. We expand upon how this alignment is created throughout the main body of the book. Private equity therefore seeks to address one of the central problems facing what is known as corporate governance: how do shareholders incentivize managers to maximize value and make them accountable for the outcome of their decisions? Some argue that private equity is an alternative long-term form of corporate governance to traditional public companies. Others see PE as a type of transitional 'shock therapy' for underperforming companies. The Discipline of Debt Corporate finance valuation theory is based on the idea that you maximize the value of any financial asset by maximizing the present value of its future cashflows. It is argued that the poor corporate governance created by the principal–agent problem allows managers to hold on to free cash generated by businesses and use it either to reduce their personal risk or to follow projects that would not otherwise be invested in: in businesses with high borrowings, with the need to repay borrowing and service the interest payments, the debt obligation itself creates a discipline that reduces or eliminates the wasteful use of cashflow. In simple terms, those who have to repay loans don't waste money. This argument is a subset of the principal–agent hypothesis, but crucially does not rely on active management by the fund manager to achieve efficiency. The financial corset of high borrowing realigns the incentives of managers to encourage economic efficiency. As we will see, the changes in the banking market over the years have eaten away at this as a credible explanation of the industry's performance. Using Debt to Reduce Taxation One of the longest standing and most commonly voiced criticisms of private equity is that it uses 'debt shields' to reduce corporation tax. The argument relies on the assumption that most or all interest charged in a company's profit and loss account is deductible against taxable profit when calculating a company's corporation tax liability. In contrast, dividend payments made to shareholders are not deductible against corporation tax. The critics argue that countries should disallow interest payments, equalizing the tax incentives to companies to use equity and debt, as illustrated in Table 1.1. This is a very simplistic argument. Firstly, interest is paid to lenders, who will be taxed on their profits. Secondly dividends are payments to equity holders out of post-tax profits. It is in many ways more accurate to think of corporation tax as a 'preferred dividend to the state' rather than a cost of the business. Shareholders who receive dividends are taxed on them as income. We enlarge on this in Chapter 2 on taxation generally. Disallowing interest costs that are then taxed in the hands of the lenders is a global increase in corporate taxation. This is especially politically attractive if people have been led to think interest has some tax advantage. Downloaded from https://academic.oup.com/book/31976/chapter/267724321 by King's College London user on 22 October 2023.

[Audio] The Private Equity Market 9 Skilled Acquirers of Unquoted Equity Private equity firms are generally very process-driven. They all tend to follow very similar, rigorous and prescriptive acquisition and due diligence processes that are the result of the experience of many thousands of transactions over the years. PE funds are very heavy users of external professional advisers to provide a suite of due diligence reports. An entire industry of accountants, lawyers, and consultants exists to support this transactional activity. Post the acquisition there are often 100-day plans to start to implement changes to any matters identified in the pre-acquisition due diligence. According to McKinsey4 the top twenty-five PE fund managers all also have in-house operational management teams whose role it is to support and accelerate the implementation of the business plan underlying the investment. PE funds now follow processes and methodologies that are the result of four decades of private equity investing and investment management. When a PE fund manager decides it is the right time to sell, they outsource the management of the sale process to investment banks, corporate finance houses, and M&A boutiques. The exit process is again very well defined and, while it continues to evolve, it remains a familiar and predictable process based on years of accumulated knowledge. Very few corporations operate in this rigorous, but expensive, way in the M&A market. Sacrificing Liquidity to Solve Information Asymmetries You can reduce risk by holding assets that are easier to sell (which gives you more liquidity) or by maximizing the information you have before and during the period you hold an investment (enabling you to manage risk effectively). If you can do both, you can achieve consistently superior returns with lower risks than any other market participants. That is one major reason why insider dealing in quoted shares is illegal. In reality you often have to trade liquidity for information rights (see Figure 1.4). Similarly, you can adopt an active investment stance and seek to influence the management of the company or a passive one and simply sell out if you perceive management to be weak or taking the business in the wrong direction. If you have decided to trade 4 https://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/private- equity-operating-groups-and-the-pursuit-of-portfolio-alpha. Table 1.1. Effects of tax deductibility of interest on post-tax profit No Debt No Debt Interest Deducted Interest Disallowed Net Profit 250 250 250 Interest −100 −100 Pre-Tax Profit 250 150 150 Disallowed Interest 100 Taxable Profit 250 150 250 Tax −50 −30 −50 Post Tax Profit 200 120 100 Effective Corp Tax Rate 20% 20% 33%.

[Audio] 10 Private Equity Demystified liquidity for information you severely limit the option to rapidly trade out of investments that are not going in the direction you anticipated. Private equity is not about trading on public markets, or trading in currencies, bonds or any other publicly quoted security or derivatives. These are the realm of managers of other funds, including hedge funds. Private equity investments are illiquid and generally traded only on acquisition or exit (although this has significantly changed since the last edition of this work, as we discuss in the chapter on secondary transactions). Generally—but not always—PE managers have good information prior to making their investment, through their due diligence processes. During the investment this level of access to information continues, both through contractual rights to receive information and through close involvement with the investee company at board level. In contrast, investors in public companies buy liquid assets (shares, bonds, and options) and generally use a trading strategy to try and make exceptional returns. Insider dealing laws are designed to prevent anybody from making exceptional returns from private information not available to other participants in the public markets. These types of investors sell out of companies when they think that they are no longer likely to generate good returns. In summary, they have high liquidity and trade on the basis of publicly available information. There are instances where companies are publicly traded but have low volumes of trades making them effectively illiquid. These types of business have often been the focus of both active management funds and PE funds looking to complete public-to-private (P2P) transactions. One of the hardest decisions for holders of publicly traded assets is when to sell, especially if the investor holds a significant stake that could move the market price. In private Equity the investors delegate that decision to the PE fund manager who has access to excellent information and sells the whole business using a well-worn and rigorous process. Information and Private Equity The theme that runs through most of these hypotheses is information as a source of improved corporate governance and information availability facilitating both better High Liquidity Insider Dealing? Quoted Financial Assets High Risk Unquoted Financial Assets High information–Low Information Low Liquidity MARKET LIQUIDITY PRIVATE INFORMATION AVAILABILITY Figure 1.4. Relationship between liquidity and information availability.

[Audio] The Private Equity Market 11 management and enabling and creating liquidity. We argue that the key to understanding private equity is the collection, management, and use of information, alongside the effects of exaggerated incentives encouraging managers to take difficult decisions and have a clear focus on the growth in the value of the business. This encompasses the information search processes of due diligence prior to and when making an investment. These expensive processes should enable better investment decisions. The post-investment imposition of both controls and systems provides the shareholder with timely information with which to judge management performance. The exaggerated rewards strongly encourage management to act decisively. The similarly exaggerated rewards to fund managers make them intolerant of management who do not deliver performance. Private equity does not sell shares in badly managed businesses; it changes the management. Thus, the availability of information, prior to and once the investment has been made, enables better corporate governance. We therefore suggest that the private equity investment model is able to achieve both economic gains from the more efficient use of resources, and to magnify and realize these gains by using this high-quality information to both change corporate behaviours and to take on greater financial risk via leverage. In this explanation, timely information, not simple incentive alignment or financial engineering, drives the industry. In the (somewhat simplistic) diagram in Figure 1.5, we argue that private equity has sought to operate in areas where the purchasers have more accessible information than the vendors by aligning with incumbent management. Vendors have reacted by creating processes to extract value from a corporate sale by maximizing competitive tension. In this model, information enables private equity to make sustainable Low White Space NPV >0 INVESTMENTS Regulated Liquid Markets Increasing Liquidity & Information Lemons Market Failure Low High High Vendors Accessible Information Set Purchasers Accessible Information Set Figure 1.5. Information and liquidity.

[Audio] 12 Private Equity Demystified above-market returns by exploiting information asymmetries. Where information is inaccessible, there is no liquidity and new products and services emerge in the white space. Where information is highly skewed towards the vendor, there is a so-called ' market for lemons', where trade fails even if buyers would want to buy the goods or services if they had better information.5 In support of this conjecture we would expect to see private equity funds spending significantly more than most other acquirers on gathering and managing information using specialist third party providers, and relatively more on information systems investments. This is indeed what the industry looks like. There are many thousands of lawyers, accountants, and consultants of all shapes and sizes who target the private equity fund managers as a key source of work. There are also 100-day plans dealing with the professionalization of management that usually start with good information systems. Against this idea we might expect public-to-private transactions (where information is less accessible) to perform less well than purely private transactions. This is a complicated test to undertake rigorously. The rules around information for public companies have changed in many jurisdictions over the years, in part in response to perceptions of insider conflicts in public company deals. Today's leveraged buyouts of public companies are very different to those of the 1980s. This may explain their decline in popularity. In summary, we argue that there has been an underemphasis on information as the lifeblood of the market. Very roughly, you might think of liquidity and trusted information as being, to some approximation, the same thing. What Risks Do Investors in Private Equity Funds Take? Blind Risk Selection Risk Market Risk Bankruptcy/ Credit Risk Liquidity Risk In any equity investment, whether public or private, there is the risk of losing the capital invested. In private equity, investments are long-term, irrevocable commitments to fund unknown, future investment opportunities. An investor commits to these risks and delegates the investment decision to the fund manager. The unknown investment risk is so-called 'blind risk': investors, and the fund managers themselves, do not know what companies they are going to invest in when a fund is established. This risk is unusually high in the early stage of a PE fund when compared to most other established investment vehicles. 'Selection risk' is how we characterize the stock-picking skills of the fund manager. It is an area of long-standing research in public market fund managers. How good a judge of a particular business and its prospects are the people you are delegating your selection to? 5 George A. Akerlof (1970), 'The market for "lemons": Quality uncertainty and the market mechanism', Quarterly Journal of Economics 84(3): 488–500..

[Audio] The Private Equity Market 13 Once invested in a particular company, the external 'market risks' of any investment are, in principle, the same whether the company is owned by a PE fund or by any other ownership structure. What differs is the 'bankruptcy risk' created and amplified by using leverage, as we discuss extensively. This is one of the defining risks of PE investment. The second defining risk of PE is liquidity risk. This reflects the fact that the commitments both to the underlying investments in the fund and to the fund itself are long-term—although, as we will discuss, this is changing. Committed versus Drawn-Down Funds When a PE fund is said to have raised $1bn they do not receive $1bn in cash from investors on day one. Investors only advance cash to the PE fund on an 'as needed' basis. What they have is access to a facility of up to $1bn that they can draw down as and when required to fund investments. It is a crucial distinction between quoted fund managers, who hold assets including from time-to-time cash on behalf of investors, and PE fund managers who only draw down cash on an as needed basis and repay any cash that the fund receives from its investment. Traditionally these commitments were not tradable, but this has changed significantly as the PE industry has matured. The market is evolving to allow some of these risks and rewards to be traded between investors. (See Chapter 2.) Furthermore, many funds now use the commitments of their investors to guarantee bank facilities that they use for the immediate drawdown of the funds. This means that the investors do not make a cash commitment when the fund invests, although they are guaranteeing the bank facility, resulting in the same risk. These loan facilities, or so-called subscription lines, have been a much-discussed feature in the past decade. We will return to the matter later in this book. What Risks Do Private Equity Fund Managers Take Themselves? To align the interests of investors and fund managers, the fund managers typically invest alongside the investors, on the same terms, in any fund. If a fund loses money, the fund managers will make the same loss on their investment, offset by any income earned from fund management fees not spent on the costs of the fund. To assess the level of alignment created by this structure you need to know how much is invested in the fund by the managers and how this amount compares to the guaranteed income that they will earn and to their net worth. It is common for managers to borrow against future fees to fund their investment in the fund. This changes the timing of the investment by the fund managers, but not its risk. It can be argued that the commitment of the managers would not be possible without the fees to underpin the loan that pays for it. If you accept this line of reasoning, the idea of alignment between the manager and the other investors is significantly weakened..

[Audio] 14 Private Equity Demystified What Rewards Do Private Equity Managers Earn? Salary Share of Fund Management Profts from the excess of fees over costs Income for Fund Management A share of all profts and income earned by the fund paid to the fund manager once a certain threshold return has been achieved. Carried Interest for Investing Others' Money Return earned as a direct investor in the fund Return for Investing Own Money The partners of the fund manager have four sources of reward. Salary: They receive a salary from the fund management company at a normal market rate. Partnership profit share: The partners own the fund management company and they therefore receive a share in the profits of that company. This represents the difference between the costs of the fund manager and the fees received from investors in the fund and, potentially, some fees from the companies that the fund has invested in. This income and its impact on incentives has become a focus of attention in the past decade. We expand on this in Chapter 3. Carried interest: They may receive something called 'carried interest' which is triggered once a minimum threshold return is achieved. Investor return: They receive a return as an investor in the fund in the same way as any other investor in the fund. The salary and partnership profit share are independent of the performance of the underlying investments. The investor return and carried interest are directly aligned and proportional to the returns earned by the investors. We look at the relationship between these two streams of return in more detail in Chapter 2. What is Carried Interest? If the fund achieves returns above a minimum threshold, the fund manager takes a preferential share of the return in the form of so-called 'carried interest' (or 'carry'). Traditionally the threshold, or hurdle rate, has been 8 per cent per annum over the life of the fund and the share has been 20 per cent of all the fund profits, although this is again changing. This is a major discussion point when considering taxation in PE (which we return to in Chapter 2). Carried interest is a share of capital gains and income paid to the fund manager. It can be thought of as a success payment for exceeding the objectives of the fund investors. There is much debate as to whether this is a fee (which would be taxed as income) or a share of capital gains which would be taxed accordingly..

[Audio] The Private Equity Market 15 What Are the Incentives of the Private Equity Fund Manager within the Fund? As we noted above, fund managers are rewarded with salaries partnership profits and carried interest. Carried interest has traditionally been 20 per cent of the profits once the investors have received an annual return (IRR) of 8 per cent. This means that there is a clear incentive to maximize the return to investors as measured by a discounted cashflow calculation, usually IRR, as this is the trigger to pay carry. Detailed calculation of carried interest is complicated, as illustrated in Chapter 2. This encourages the maximum use of debt and minimal use of equity in any investment. This is in a sense obvious: debt is cheaper and equity more expensive. The constraint on how much third-party debt can prudently be borrowed is the limiting factor. This is discussed in Chapter 3. Within a fund the incentives of the fund manager are to: minimize the use of investors' cash; maximize leverage in each investment, subject to risk; act quickly to reduce the value needed to exceed the hurdle rate; and to increase the value of the equity by: repaying debt; and/or increasing enterprise value; negotiating a low hurdle rate. What Are the Incentives of the Private Equity Fund Manager when Fund Raising? In fund raising the incentives are very different. People are motivated by nominal returns: you cannot spend rates of return; you can only spend cash. Large funds not only generate higher fees and therefore proportionately higher revenues but, as they do bigger deals, the successful ones generate more pounds or dollars of carried interest. A 1.0 per cent fee on a fund of $10bn generates fees of $100m per annum. A 2.0 per cent fee on a £300m fund generates £6m per annum. These are guaranteed incomes to the fund management business. Anything not spent on the costs of those businesses are shared by the partners. There are very big incentives to be big in all fund management businesses. In private equity fees are high, so the incentives are stronger. This has led to the growth of giant private market funds that have multiple investment funds following multiple investment strategies. The economies of scale in these large fund managers are not currently reflected in the fees charged by their individual funds, which are broadly the same as similar sized funds operating in a defined niche. When fees become the largest part of a manager's income, the idea of alignment at the heart of private equity is challenged. Arguably there is a point at which a new principal–agent issue is created between the investors in the fund. Investors want prudent investments in a.

[Audio] 16 Private Equity Demystified diversified portfolio generating capital gains. The manager wants to maximize assets under management (AUM) to generate a certain fee income. Furthermore, fee profits are earned early in the life of the funds whereas carried interest is earned much later, after the fund's performance has been realized. We return to this tension in the chapter on the contract that governs the relationship between investors and managers: the Limited Partnership Agreement (LPA). What Is Leverage and What Role Does It Play in Private Equity? Using borrowed money alongside your own reduces the amount you have to invest and so amplifies the returns on any particular investment. This amplification has various names: in the US it is called leverage, in the UK it was traditionally called gearing. They are the same idea. In economic theory it has been shown that under certain assumptions the capital structure of a company cannot change the fundamental economics of a business. The Modigliani–Miller hypothesis6 is a central idea in corporate finance theory. For our purposes we only need to understand that it suggests that in a perfect market a business cannot achieve enduring competitive advantage through changes in its capital structure: that is, you cannot make above-market returns by changing your debt/equity ratio. The mechanics of leverage are not complicated. Debt is a prior claim on the cash flows and assets of a business. Equity is a residual claim on the profits and net assets. Therefore, when you use only your own money as equity in an investment, the return on the investment is the same as the return on your equity (Figure 1.6). If external debt (which has a fixed return) is used to fund the investment, the prospective returns are increased because the equity is reduced and yet it still captures all of the capital gain (Figure 1.7). It is just like the effect of a mortgage on a house. 6 F. Modigliani and M. Miller (1958), 'The cost of capital, corporation finance and the theory of investment', American Economic Review 48(3): 261–97. F. Modigliani and M. Miller (1963), 'Corporate income taxes and the cost of capital: a correction', American Economic Review 53(3): 433–43. With no Debt, Equity Return = Total return +10% 100 Equity 110 Equity Buy Asset Value 100 100 100 0 0% 100% 110 10% 10% 10% 0% 110 110 0 0% 100% Funded By Debt Equity Total Debt % Equity % Sell %Return Figure 1.6. Effects of leverage—no debt Source: The authors Downloaded from https://academic.oup.com/book/31976/chapter/267724321 by King's College London user on 22 October 2023.

[Audio] The Private Equity Market 17 We can easily expand on this simple example and look (Figure 1.8) at what happens at any particular ratio of equity to debt (X axis) and different growth rates to the returns on equity (Y axis). We can also examine what happens at negative growth rates. What we find is that when we have high levels of borrowing, returns are amplified. Notice that the amplification goes in both directions. Bad deals are really bad and good deals are really good, and for a partnership with unlimited liabilities this would be the case in reality. However, there is a cap on the amount you can lose in a limited company or a limited liability partnership. The most any shareholder or partner can lose is all their investment. This means that the amplification is asymmetrical: you can make a return of up to infinity, but you can only lose your initial investment. The graph therefore should look like the one in Figure 1.9. Either way, what you can see is that the effect of borrowing is to amplify returns, NOT increase them, as it works in both directions, up and down. Buy Asset Value 50 Debt 50 Debt 50 Equity 60 Equity 100 50 100 50 50% 50% 110 10% 20% 10% 0% 60 110 50 45% 55% Funded By Debt Equity Total Debt % Equity % Sell %Return With 50% Debt, Equity Return = 2 ×Total return +10% +20% Figure 1.7. Effects of leverage—50 per cent debt Source: The authors –600% –400% –200% 0% 200% 400% 600% 800% 1000% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% % Return on Equity Percentage of Money Borrowed Equity Returns at Different Leverage/Gearing % With Unlimited Liability –50.00% –25.00% 0.00% 25.00% 50.00% 75.00% Figure 1.8. Effect of leverage on return on equity at various overall investment returns with unlimited liability Downloaded from https://academic.oup.com/book/31976/chapter/267724321 by King's College London user on 22 October 2023.

[Audio] 18 Private Equity Demystified A colleague of one of us7 has made the following observation. If assets trade at their net present value, leverage cannot amplify the returns earned. This follows from the work by Modigliani and Miller in the 1950s. Both were awarded Nobel Prizes: Modigliani in 1985, Miller in 1990. The argument in essence is that if markets are efficiently driving transaction values to their net present value, leverage cannot increase the returns, as the returns are competed away by the sale process. This lies at the very heart of all debates about private equity returns. If you believe that, on the whole, markets are efficient and that the buyers must pay a fair price that equates to the net present value of the investment, you cannot make consistently higher returns by financial engineering. If, on the other hand, you think that the market for corporate control is imperfect, or systematically inefficient, you can hypothesize constantly higher returns, but have to explain why the market is failing. It is also possible to hypothesize that markets move between states of efficiency and inefficiency creating investment opportunities from time to time. Much work has been undertaken by academics and others to try and establish what proportion of the return from a private equity investment comes from: (1) increases in total investment value, or (2) the effect of leverage on equity returns. This so-called 'attribution analysis' is a hot topic in both academic studies and the discussions of returns achieved by funds. We return to it later. What Impact Does Leverage Have on Bankruptcy Risk? The other side of this amplification of return is increased financial risk. We can characterize risk as being crystallized at the point that the value of the project is less than the value 7 Ludovic Phalippou (2018), Private Equity Laid Bare. –100% 0% 100% 200% 300% 400% 500% 600% 700% 800% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% % Return on Equity Percentage of Money Borrowed Equity Returns at Diferent Leverage/Gearing % With Limited Liability –50.00% –25.00% 0.00% 25.00% 50.00% 75.00% Figure 1.9. Effect of leverage on return on equity at various overall investment returns with limited liability Downloaded from https://academic.oup.com/book/31976/chapter/267724321 by King's College London user on 22 October 2023.

[Audio] The Private Equity Market 19 of the debt. Equivalently, the project has negative net worth when the equity value has been consumed. As there is less equity in a geared/levered structure, the probability of becoming insolvent is higher than an ungeared/unlevered structure. As gearing/leverage increases, other things being equal, the probability of becoming insolvent rises. This risk of failure by becoming insolvent is generally termed bankruptcy risk. Private equity investors use debt to consciously create financial risk in order to amplify the return on equity. We return to this idea frequently. It is vital to appreciate that risk and reward are two sides of the same coin. It is always possible to generate risk without reward, but if you can generate rewards without risk, you have created the economic equivalent of a perpetual motion machine, which is generally impossible. Leverage in Funds versus Leverage in Investments It is crucially important to understand that leverage can be found at different levels of many financial structures, and its impact differs. Private equity funds traditionally use debt in each individual investment, but have traditionally had none within the fund, although as we will discuss, this has changed. The investments stood or fell on their own two feet, with no recourse to the fund. Therefore, while there is bankruptcy risk in each investee company, there was generally none in the fund. This is changing. In contrast many other types of fund manager have always used leverage within the fund to amplify returns. In a similar way a trading company may have some borrowings on its or its subsidiaries' balance sheets, often cross-guaranteed by the other companies in the trading group. The risks of leverage are most threatening when they are compounded: where a geared fund owns geared investments, returns can appear spectacular, but will be at greater risk. There is therefore a mix of incentives leaning towards the use of gearing to amplify returns within any type of fund. The market pressure is to increase borrowings and give investors more liquidity, which if unfettered will lead to increases in risk within the fund structures. Over the past few years the use of debt within private equity funds has started to become a standard feature. This creates an increase in the risks in the market and distorts comparisons of returns. We discuss this change and its implications below and more fully in Chapter 2. What Market Risks Does Private Equity Create? We believe that this distinction between leverage in a fund and in its investments is important in understanding the market risks created by hedge funds and private equity funds, as well as for informing regulatory responses to the systemic failures seen in the past. We have argued that the traditional private equity fund structure has operated to limit systemic risk by offering long-term, illiquid, unleveraged investment assets mostly to institutional investors with large diversified portfolios. However, pressure to increase.

[Audio] 20 Private Equity Demystified leverage within funds and to provide liquidity to investors not matched to the liquidity of the underlying assets is creating increased risk. Whether this is systemic is debatable. Unlike banks, private equity funds do not hold customer deposits or have any important role in the facilitation of trade in the wider economy. They do however take investments from institutions that are important to the wider society, such as pension funds and insurance funds. Increased risk in private equity funds is therefore an increase in risk to the investors. Whether this is compensated for by superior returns is one key question to consider. The second important consideration is the impact on the liquidity of investors as private equity allocations increase. You cannot easily sell a position in a private equity fund, although the markets are developing. We discuss this in the chapter on secondary transactions. The debt-free structure of a private equity fund was, in most European jurisdictions, a market-driven norm, not a regulatory requirement. We return to this when we discuss regulation in Chapter 2. A Financial Canary in the Coal Mine? One might characterize the private equity industry as a group of early adopters of financial innovation, rather than the creators of that innovation. Because of the amplification caused by the use of leverage, coupled with the early adoption of new techniques and practices, if private equity is suffering or booming it may be a sign of things to come in the wider financial markets and economy. Certainly, the rise of mega-buyouts and the loosening of bank terms leading up to the financial crisis was symptomatic of structural issues that heralded problems elsewhere. As such, private equity is potentially an early warning system; a financial canary in the coal mine. As we write, leverage is high and debt is cheap, and transaction prices are accordingly also high. Many of the graphs we will use in this book suggest that we are at the top of a cycle, but we, along with almost all other commentators, have no way of forecasting when the downturn will start or how sharp and protracted it will be.8 How Do Private Equity Funds Control Their Investments? The ability to act decisively comes from the fact that a private equity fund manager actively manages and controls each company using: board representation; contracts which require, or limit without the consent of the investors, certain actions of management; voting control over all material matters; full access to company information and board minutes; and a culture and incentive system that rewards success highly and penalizes failure. These rights are widely spread in the contracts that bind any transaction together. We discuss these later when we walk through a typical private equity investment term sheet. 8 This was written before covid19. See the addendum for an update written as the pandemic broke..

[Audio] The Private Equity Market 21 A Summary of the Core Ideas: The 4 As—Amplification, Alignment, Active Management, and Attention to Detail Private equity firms are strategic investors generally seeking to create and realize value. To achieve this, they follow a series of strategies that can be crudely characterized under the following alliterative headings. Amplification: Private equity uses debt to consciously create a level of financial risk that exaggerates the returns on equity. Alignment: Equity incentives are used to create potentially unlimited incentives to motivate people to generate (predominantly) capital gains. Active management: The body of research on investment performance generally shows that a passive trading strategy of 'stock picking' does not generate materially higher long-run returns than simply choosing to buy indices of stock markets. This has been reinforced by the imposition of insider-trading laws that prohibit the use of private information to achieve superior returns. Those who have generated longterm outperformance since the imposition of the insider trading laws are those who have actively intervened to improve the performance and management of businesses. This appears to be as true of a few public investors, such as Berkshire Hathaway, as it is of private investors, such as the private equity firms. The form of this active management has evolved over the years, but it remains a key feature in explaining the performance of private equity investments. Attention to detail: Private equity is transactional, whole companies are bought and sold. In consequence a great deal of due diligence is done on each deal and the transaction structure. Great emphasis is placed on measuring and managing every relevant aspect of a business's performance, including, for example, tax structuring. Private equity is very process driven in the way it transacts. They do all of this while benefiting from excellent information on the businesses they own and control. We expand on each of these themes throughout this work. A Brief History of Private Equity While there have always been equity investments made outside the public markets, private equity as we understand the term today emerged in the 1980s from, broadly, two preexisting pools of funds: venture capital and development capital. Venture capital (VC) provides equity capital to early and emerging businesses. Development capital provides equity capital to expand existing businesses. The term private equity was adopted from the late 1980s. Before then it was more common to hear institutions refer to themselves as venture capitalists in the UK and leveraged buyout (LBO) firms in the US. 1960/70s: Asset Stripping and Financial Assistance In the 1970s in many developed countries it became illegal to use the assets of a target company to give security to a lender to a bidder for that company. Essentially you could.

[Audio] 22 Private Equity Demystified not promise to give security on assets you did not own. This was specifically designed to stop the asset stripping that had been seen in the late 1960s. In the 1960s corporate raiders sought out companies with undervalued assets, bought the businesses and then closed the business down and sold the assets. This left the unsecured creditors and employees to suffer a loss. The financial assistance prohibition aimed to prevent this by making it a criminal offence to asset-strip in most countries. However, an unintended consequence of this legislation was that it prevented the rescue of viable companies many of which were subsidiaries of larger failing businesses. These subsidiaries could not provide security to a purchaser's bank that wished to lend money to help acquire and rescue a business. To reverse this unintended prohibition, and to encourage the rescue of viable businesses, a change was made to the law in a number of countries. In the UK, the Companies Act 1981 allowed UK companies to give financial assistance under certain tightly controlled circumstances. The law on financial assistance broadly required the directors to make a statutory declaration that as far as they knew at the completion date of the transaction, the company would be solvent for the next twelve months. If they made the declaration knowing it to be untrue, it was a criminal offence. 1980s: First Buyout Boom Following the legal change on financial assistance in most jurisdictions, the number of buyouts grew rapidly. Initially growth was seen in the US whereas in Europe the market was overwhelmingly dominated by the UK. By the mid-1980s, 3i, which at that time was jointly owned by the Bank of England and the major clearing banks, had an overwhelmingly strong position in Britain. Other early UK participants were subsidiaries of banks and other financial institutions that had historically focused on development capital and other financial investors with a background in venture capital. 1980s: 'Hands-Off, Eyes-On' Virtually all early UK funds were generalist investors who had skills in financial engineering and transactions but had little hands-on management input. Investors closely monitored their investments, but the underlying philosophy was passively to back management to manage. Mid-1980s: New Entrants The returns earned by the early buyout investors were very good. This led to a growth in the funds committed by existing investors and to the emergence of new funds raised by groups of investors who wished to enter the market. In the UK many of these funds' founder managers were from the relatively small pool of experienced investors (often they were ex-3i executives). In the US they tended to be from consultancy and investment banking backgrounds..

[Audio] The Private Equity Market 23 1989: Junk Bonds and Mega-Deals V1.0 In the US two factors enabled the market to expand rapidly. First, a market for subprime 'junk' bonds was created. This enabled investors to issue high yield debt to fund acquisitions. Secondly, the early funds generated returns that were widely held to be outperforming the market. This led to ever-larger funds, capable of doing ever-larger deals. The peak of the market was the iconic buyout of RJR Nabisco in 1988 for approximately $23bn. Due to the relatively small size of the European funds, the capacity of the European buyout market was severely limited and in consequence many transactions were syndicated between equity investors. To put the scale of the industry in context, a large European buyout during this period was generally defined as one in excess of £10m; in the current market it might be defined as perhaps £0.5bn−£1bn or thereabouts. At the end of the 1980s the largest deal in Europe was the 1989 Isosceles buyout of Gateway Supermarkets for £2.2bn. Captives versus Independents By the end of the first wave of buyouts in the 1980s the industry was characterized by a split between so-called 'captive funds', owned by a large corporate parent, and independent firms having the partnership form that we see as the commonest structure today, plus, in Europe, 3i. Yield versus Capital Gain Some smaller captive funds and 3i tended to be longer-term holders of an investment (compared to current structures—see Chapter 2) without an explicit exit policy. They demanded a higher yield from their investments. Independent firms were generally structured as 10-year funds (as we see today) and therefore were more focused on generating capital gains with a defined exit policy and had lower yield requirements. 1990s: Blow-Up and Buyouts of Captive Funds Following the impact of the recession of the early 1990s, and high interest rates, many leveraged investments struggled or failed. Appetite to support in-house private equity declined leading many of the captive funds themselves to be bought out from their parent companies by their partners. Virtually all rebranded themselves as private equity or buyout firms and abandoned any pretension to venture capital activities (Table 1.2). In this limited sense the partners of many private equity fund managers have taken the risks and earned the rewards of a manager in a buyout. 2000s: Early Secondary Transactions One of the other consequences of the end of most captive private equity funds was the emergence of portfolios of assets that were no longer wanted by their investors. A small.

[Audio] 24 Private Equity Demystified group of secondary funds emerged that specialized in structuring transactions to buy these assets, often at a discount to their net asset values. The largest of these transactions was the £1bn purchase of the private equity portfolio of NatWest Bank as part of its defence against a hostile takeover by RBS. Early secondary transactions were often seen as a sign of a failure by the private equity manager to achieve satisfactory returns. They were rarely openly discussed. Hands-on Investors and Sector Specialization As competition for transactions increased, the need to generate value in individual investments increased. This led to a variety of strategies aimed at increasing the success rate and the value of each success to funds. Investors generally became much more active in the management of each individual investment. Many investors began to focus on specific industries and sectors to gain an advantage over generalist investors. Today most firms have a sector bias and an active investment style. Globalization and the Growth of Global Mega-Funds In the late 1990s and after the turn of the century the market split in two: the largest private equity funds have become increasingly international in their outlook, while in the mid-market the businesses have become more focused on specific sectors or types of business. The trend in globalization has led to a growth in the number of non-UK investors based in London seeking UK and European transactions. 2005–7: Boom The prolonged period of economic growth with low inflation from the mid-1990s to the 2008 financial crisis was characterized by ever larger funds, larger deals, greater complexity in structures, greater leverage, and an explosion in the size of private equity as a global Table 1.2. Predecessors of selected UK private equity firms Name of firm Predecessor firm Type of predecessor Permira Schroder Ventures UK parent captive / employees Apax Partners Alan Patricoff Associates (Europe) US affiliate independent CVC Capital Partners Citicorp Venture Capital (Europe) US parent captive Cinven Coal Board Investment Managers Venture Capital Public sector pension fund manager 3i Group Industrial and Commercial Finance Corporation Clearing banks and Bank of England Terra Firma Nomura Principal Finance Group Japanese parent captive Charterhouse Capital Charterhouse Development Capital UK parent captive.

[Audio] The Private Equity Market 25 industry. It was still a poorly understood, little reported industry and operated from a number of unregulated jurisdictions. The debt markets also metamorphosed and banks that had previously held loans on their own balance sheets sold them into the wholesale market. They ceased to earn the majority of their income from net interest payments and became fee-earning businesses that parcelled up loans to be sold on to other financial institutions. Innovation in the debt markets led to the emergence of markets in new forms of derivatives. Most of these instruments were designed to allow risk to be traded. This has always been one of the functions of derivatives, but when they were stripped from their underlying loans, they became tradable assets creating some perverse, unintended incentives (see Chapter 2). New businesses, such as the Icelandic firm Baugur, emerged that mimicked the use of leverage seen in private equity financial structures in individual investments but without certain controls that operate in the traditional fund structures: they created leveraged funds to make leveraged investments, doubling up the risks and apparent rewards. 2007–8: Bust By 2007 the wholesale debt markets were opaque and poorly understood by most. There was an implicit assumption that there was an available appetite for debt in the global market which was effectively infinite or unlimited. This allowed banking institutions to fund themselves using facilities that were renewed continuously in the highly liquid debt markets. When the default rates on US mortgages turned out to be higher than expected, it was unclear who was holding the associated risk. In the absence of any clear information about who was going to be making losses, banks and institutions started to hold on to all the cash that was available to them and reduced or stopped lending to the wholesale markets. This meant that wholesale credit dried up and banks reliant on renewing facilities were unable to refinance and became insolvent. Initially, smaller banks struggled and failed, but as the scale of the confusion spread, the world's largest institutions turned to governments to provide capital and guarantees. In the case of Lehman Brothers, the US government declined to rescue them and the investment bank failed. The impact on the private equity market was abrupt and precipitous. Banks needed to hold cash rather than to generate lending. Deal volumes, which are reliant on leverage, collapsed. The largest deals were the worst affected. Those who had used debt within their fund structures rapidly faced insolvency as there was a mismatch between the dates they were expecting to realize their investments and the date that their borrowings were repayable. 2009–12: Hangover The aftermath of the financial crisis showed both the strengths and weaknesses in the private equity model. On the positive side of the balance, the traditional 'ten plus two' fund (see Chapter 2) was bankrupt remote: it could not spread risk because the whole risk fell.

[Audio] 26 Private Equity Demystified on its partners. This is an important and little publicized fact: private equity fund structures in a limited way stopped the creation of systemic risk. However, perverse situations arose between fund managers and their partners. Many funds had raised billions of dollars prior to the crash on the assumption that leverage would be available to support deals. They found themselves charging fees on capital that would be unlikely to be deployed. Investors were understandably unhappy. The period of extremely low interest rates that has followed the crisis has prevented the feared collapse of many companies with high levels of borrowings, including buyouts and other private equity investments. Had the recession been accompanied by high interest rates, the failure rate would certainly have been materially higher, in all types of business. In the US, buyouts have been funded by bonds and debt funds for many years. In the UK, prior to the financial crisis it was much more common that banks funded buyouts. Among the leaders in the UK market were RBS and HBOS and therefore, when they themselves required rescuing, debt funding to buyouts contracted sharply. Furthermore, the regulations that govern banks' requirement to maintain a strong balance sheet were altered after the crisis. The amount of capital that a bank had to hold against long-term loans was significantly increased. Long-term in this context was (broadly speaking) defined as five years or more. In consequence the amount of capital a bank had to put aside to support buyout loans over five years increased, and the price of loans increased sharply to generate the return on capital that banks required. As a rough rule of thumb, loan margins increased from around 2.25 per cent over LIBOR to 4.5 per cent over LIBOR. LIBOR is a benchmark rate of interest at which banks lend to each other. It is closely correlated to the Bank of England base rate. LIBOR will be replaced in 2021, but the principle will remain the same. Bank arrangement fees also shot up from around 1.0 per cent of the amount borrowed to 3.0 per cent. The cost impact was not immediately felt because the Bank of England base rate (and all other global interest rates) were reduced to all-time lows by the central banking authorities. In effect base rates fell more than margins increased, so borrowers paid similar overall costs. 2012–19: Debt Innovation in Europe The increase in margins and fees and the vacuum left by the collapse of lending by the European banks attracted new entrants and start-ups in the buyout debt market. These are debt funds rather than banks. They operate a very similar model to the PE fund. They raise institutional commitments in a limited life fund and earn fees and carried interest if they are successful. These funds have long operated in the US market. In essence the European market was slowly transformed. It started as a market led by banks and bank syndicates in the lower-mid market with investment banks underwriting and placing high-yield bonds in larger deals. First the depth of the syndication market reduced as banks withdrew from risky lending. Those who remained saw the opportunity to put up prices, and this attracted new entrants who largely displaced the banks from the leveraged finance market (Figure 1.10). We discuss these changes in Chapter 4. Downloaded from https://academic.oup.com/book/31976/chapter/267724321 by King's College London user on 22 October 2023.

[Audio] The Private Equity Market 27 2012–19: Innovation in Secondary Trading The secondary markets for private equity funds are the place where limited partners (LPs) buy and sell their investments in PE funds. They are by some measures larger than the primary markets. It is important to be clear on terminology when talking about secondary PE. There are companies that undergo more than one buyout: these are secondary (or tertiary, or whatever) buyouts. There are also completely unrelated and different sales of commitments and investments within a fund that are called secondary trades. There has been a growth in both, but here we are referring specifically and exclusively to trades in fund positions, not buyouts. Large LPs may hold investments and commitments to many PE funds at any particular time. At the date of writing, for example, the European Investment Fund (EIF) has commitments to some 532 PE funds and CalPERS, a large US public pension fund, reported live investments in 258 PE and VC funds. Monitoring and managing such large portfolios is a significant task. Many investors have sought to simplify their portfolios and to actively manage their exposure to the life cycles of funds. For example, managers who are comfortable with blind risk in new funds may wish to sell their mature unquoted fund positions to invest in more new funds. This allows those who do not wish to have blind risk to buy into the unquoted market after the investments have been substantially made. This enables investors to 'manage the J curve', which we will explain in the next chapter. 2012–19: Managed Accounts, Co-Invest and the Canadian Model One of the features of the market that has grown significantly over the past decade has been the prevalence of new fund management arrangements and investment strategies. These include the so-called Canadian Model, Managed Funds and co-invest arrangements. We deal with these more extensively in Chapter 2, but in summary these are 0 100 200 300 400 500 600 700 800 900 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 PRIVATE DEBT-Assets Under Management Figure 1.10. Private debt: assets under management by year ($bn) Source: Preqin Downloaded from https://academic.oup.com/book/31976/chapter/267724321 by King's College London user on 22 October 2023.

[Audio] 28 Private Equity Demystified structures that reduce the cost and in some versions places controls on the discretion of the PE fund manager to invest. Multi-Asset Managers and the Search for Yield Most large PE fund managers are no longer focused exclusively on private equity and some are themselves now listed entities. They manage multiple different types of funds ranging from LBO funds to real estate and private debt. The market is separating into large global asset managers raising funds in multiple private markets and small focused equity funds, typically geographically constrained and sector-focused. In 2019 both the equity and debt markets were separating into the large and the niche, with few in between. 2019–20 The Top of The Cycle? Most seasoned commentators and practitioners in Europe are confident that we are writing at a point near to the top of the market. Interest rates have been artificially low for a decade and this has inflated asset prices. Lenders therefore see good security and good interest cover (see Chapter 4) and have been aggressively lending to leveraged transactions. The amount of debt is often expressed at a 'multiple of EBITDA' (earnings before interest, tax, depreciation, and amortization—we explain this is in Chapter 3). EBITDA multiples are, as we write in 2019, near all-time highs. How Big Is the Private Equity Market? There are three important measures of the size of the buyout market: the amount invested in private equity (Figure 1.11), the amount of new funds raised or committed (Figure 1.12), and the amount of assets under management (AUM) (Figure 1.13). The figures illustrate both the overall growth in the private equity market and its cyclicality. Following the dot.com boom there was a decline in the level of new funds raised. From 2005 onwards fund raisings grew dramatically, peaking in 2008. After the financial crisis the volume of deals and funds raised fell sharply: global transaction volumes fell in value by approaching 50 per cent. This reflected two key factors. First, even if there had been deals to do, the banking market was severely affected by the crash and there was therefore no debt availability to fund leveraged deals. As there were fewer larger deals, the existing capital commitments were not drawn down as rapidly as had been expected. Existing capital was not deployed. As a result 'dry powder' (the term for undrawn commitments) continued to rise during the crisis, before naturally declining as funds ended their investment period. Secondly the financial crisis damaged the balance sheets of all investors and in consequence there was less ability to invest in alternative assets. Looking at the buyout data for Europe over a longer period gives a clearer picture of the cyclicality of the market and the importance of private equity in the overall market for control of corporations. Downloaded from https://academic.oup.com/book/31976/chapter/267724321 by King's College London user on 22 October 2023.

[Audio] The Private Equity Market 29 As illustrated in Figure 1.14, the market for buyouts was rising in a cyclical trend up to the 2004–8 boom. During and following the financial crisis the market fell back to levels not seen since the mid-1990s. The lack of availability of debt caused the value of the market to crash by around 90 per cent as large buyouts disappeared. The recovery began in late 2009 and by 2018 numbers and values were at approximately 2005 pre-crash levels (Figure 1.15). How Significant Are Larger Deals in the Private Equity Market? Most public interest and much academic research has been focused on the large buyout market. However, the data shows that buyouts with a deal value of £100m or more 0 200 400 600 800 1000 1200 1400 1600 1800 2000 1 2000 4 2001 3 2002 2 2003 1 2003 4 2004 3 2005 2 2006 1 2006 4 2007 3 2008 2 2009 1 2009 4 2010 3 2011 2 2012 1 2012 4 2013 3 2014 2 2015 1 2015 4 2016 3 2017 2 2018 1 2018 4 Value USD bn Quarterly Global Transaction Volumes Q1 1982-Q2 2019 Quarter Number of deals LTM Average Figure 1.11. Global private equity investments, global aggregate value of private equity-backed buyout deals 0 100 200 300 400 500 600 700 0 500 1000 1500 2000 2500 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Private Equity Funds Raised Globally NO. OF FUNDS AGGREGATE CAPITAL RAISED (USD BN) Value USD bn Figure 1.12. Global private equity funds raised ($bn) 2000–18 Source: Preqin Downloaded from https://academic.oup.com/book/31976/chapter/267724321 by King's College London user on 22 October 2023.

[Audio] 30 Private Equity Demystified represented only a tenth of total buyouts by number, despite representing almost nine-tenths by value (Figure 1.16). Buyouts are therefore a very important feature of the UK mid-market but large buyouts are a small fraction of the UK private equity market by number. This bias towards discussion of larger transactions is a feature of both media commentary and academic research. In part it reflects data availability (smaller transactions are harder to monitor and analyse) and in part a natural interest in blockbuster deals. Nevertheless, it is of fundamental importance when discussing, reporting on, or regulating private equity to have regard for the vast majority of transactions which are smaller than £100m. 0 1000 2000 3000 4000 5000 6000 7000 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Assets Under Management Year PRIVATE EQUITY REAL ESTATE INFRASTRUCTURE PRIVATE DEBT NATURAL RESOURCES Value USD bn Figure 1.13. Private equity assets under management by strategy Source: Preqin 0 200 400 600 800 1000 1200 2000 2002 2004 2006 2008 2010 Year 2012 2014 2016 2018 $bn TOTAL BUYOUT GROWTH BALANCED Figure 1.14. Total committed capital by investment strategy Source: Preqin.

[Audio] The Private Equity Market 31 The Death of the Management Buyout? Buyouts come in a variety of flavours, but the two simple definitions used relate to where the management team are prior to the deal. If the management are incumbent in the company, it is a management buyout or MBO. If they are a new team brought into the company as part of the deal, it is a management buy-in or MBI. In the data below, institutionally led transactions where management changes are classified as MBIs, although they are often also called IBOs, or Institutional Buyouts. 0 20000 40000 60000 80000 100000 120000 140000 160000 180000 200000 0 200 400 600 800 1000 1200 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 Value €m Number Number Value €m Figure 1.15. Value of European buyouts (€m) 1985–2018 Source: CMBOR/Investec/Equistone Partners Europe 0 10 20 30 40 50 60 70 80 90 100 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Year 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Share of Buyout market number (%) Share of Buyout market value (%) Figure 1.16. £100m buyouts as a percentage of the market by number and value (UK) 1985–2018 Source: CMBOR/Investec/Equistone Partners Europe Downloaded from https://academic.oup.com/book/31976/chapter/267724321 by King's College London user on 22 October 2023.

[Audio] 32 Private Equity Demystified Breaking the data down by MBO and MBI reveals a clear trend (Figure 1.17). Management buyouts have been declining in importance for around twenty years. The days when management decided to attempt to acquire businesses that they worked for, backed by PE funds, are largely in the past. By value the trend is starker (Figure 1.18). 0 100 200 300 400 500 600 700 800 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 Number MBO No. MBI No. Year Figure 1.17. Buy-in versus buyout by number (Europe) 1985–2019 Source: CMBOR/Investec/Equistone Partners Europe 0 20000 40000 60000 80000 100000 120000 140000 160000 180000 200000 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Value MBO Eur m MBI Eur M Total Eur m Year Figure 1.18. Buy-in versus buyout by value (Europe) 1995–2018 Source: CMBOR/Investec/Equistone Partners Europe.

[Audio] The Private Equity Market 33 It is arguable that the distinction between MBOs and MBIs is now essentially obsolete. In today's market, PE firms are the buyers of businesses, not the management. Whether they choose to keep or change the incumbent management is their decision, often taken post investment. This is a complete change from the origins of the PE industry when management were at the centre of initiating a transaction. The Company Auction Process and Compressed Investment Returns The reasons for this shift relate substantially to changes in the way vendors manage the process of selling companies. We give more detail on auctions in Chapter 3, but briefly, in the early days of the buyout industry, management often expected to lead a transaction. They would appoint advisers who would raise funds to acquire a business from the vendors. In this process vendors had to attempt to manage a process that could lead to a trade sale or a management buyout. The potential trade purchasers were understandably concerned about the impact on the business if the management team were the losing under-bidders: how motivated would the losing management team be? Similarly the vendors had to manage the potential conflicts of interest with their own management teams who were both running the business and trying to buy it. The problems created by a potential management buyout were therefore twofold: firstly the risks of a deal to other potential buyers increased and secondly there were real conflicts of interest for managers upon whom all parties were relying for information. These conflicts and risks reduced the number of bidders willing to partake in any sale process. Much research on management buyouts focused upon whether the sale process itself appropriated value to successful buyouts. The idea is that since managers could use inside information only available to them, a potential buyout would drive away competing bidders, and so the value of the business would be reduced. This fall in value would be a transfer from the seller to the buyer. Therefore management buyouts would start with an advantage: they could buy the business cheaper. The solution to this was the wresting of control of the process from management teams, the creation of the company auction process by corporate financiers, and the introduction of disclosure and governance rules for quoted company transactions. In an auction a sales document is prepared and circulated to potential interested parties including both private equity and trade buyers. The level playing field should reduce conflicts for management and capture more of the value for the vendor. It also encourages private equity houses to team up with external managers in an attempt to gain a sector advantage, giving a boost to the MBI/IBO numbers at the expense of the MBO numbers. Auction processes are virtually ubiquitous both in larger transactions and in disposals by private equity firms (secondary buyouts). If auctions generally increase the price paid for buyouts by acquirers, there is a transfer of value from the purchasers to vendors. If prices are not higher as a result of the process, there is a leakage of value due to transaction costs. Other things being equal we would expect either of these to reduce returns when compared to past performance. In addition to paying an increased price, there is a further downside as purchasers with poorer access to.

[Audio] 34 Private Equity Demystified management in any auction process take on more risk (as they lose access to management's inside view). This again might be expected to reduce returns in private equity overall. There has been considerable research on returns to private equity investors, which we discuss at length. Within this research is a consistent trend towards so-called compression of returns. It is widely observed that returns to private equity are no longer as dispersed as they were. The difference between the best and worst groups of funds is falling. This compression is consistent with greater maturity and competition in the market. More specifically the compression may be due to the creation of more controlled and managed sale processes around businesses. It is our conjecture that the company auction process has been instrumental in leading to this maturity in what is called by academics the market for corporate control. Deal Initiation and Proprietary Deal Flow Private equity funds predictably do not like competitive auctions. They receive poorer access to the company than in an unfettered private process and have to bid against other interested parties, which forces up the price. They therefore invest heavily in 'deal initiation' (or 'deal origination') in order to pre-empt these competitive processes. The transactions that a firm initiates itself are so-called 'off-market' deals. When fund raising, much play is made of these proprietary deals—that is, those 'owned' by the fund in some undefined sense. More proprietary deal flow should in principle mean less competition, lower prices, better access to information, and therefore the holy grail of both higher returns and lower risks. This is what drives a large proportion of especially mid-market deal initiation activity. A 'good eye for a deal' is one of the key skills for a successful investor. What Have Been the Biggest UK Deals? By far the largest European transaction was the 2007 £11bn public-to-private buyout of Boots plc, led by KKR, to create Alliance Boots. As Figure 1.19 illustrates, from around the turn of the century the frequency of £1bn buyouts sharply increased in the UK. As we described earlier, this stopped in the wake of the financial crisis and re-emerged from 2014 onwards. A list of the deals included in Figure 1.19 is at Appendix 1. Of the largest transactions shown in Figure 1.19 none failed in the formal insolvency sense, but a number delivered no equity value to their original investors. More information can be found on these and other larger transactions by looking at the Walker Guidelines Monitoring Group website.9 Figure 1.20 shows the largest failed buyouts by the year the deal completed against the year of failure. (A list of the deals included in this figure is at Appendix 2.) The number of years to failure is given by the diagonal lines. There is no clear failure pattern and it is 9 http://privateequityreportinggroup.co.uk/..

[Audio] The Private Equity Market 35 1985 0 2000 4000 6000 8000 10000 Enterprise Value of Transaction ₤m 12000 14000 Deal year 1990 1995 2000 2005 Year of Completion of Transaction 2010 2015 2020 2025 Figure 1.19. The largest buyouts by year and enterprise value Source: CMBOR/Investec/Equistone Partners Europe 1985 1985 1990 1995 2000 2005 Year of Failure 2010 2015 2020 Failed in 15 years Failed in 10 years Failed in 5 years Failed in 0 years 2025 Largest LBO failures by Year of Investment and Years To Failure 1990 1995 2000 2005 Year Transaction Completed 2010 2015 2020 Figure 1.20. Large buyout failures by year of investment, year of failure and original enterprise value Source: CMBOR/Investec/Equistone Partners Europe.

[Audio] 36 Private Equity Demystified certainly not the case that most fail quickly. To the extent that there are patches of failure in the late 1980s, 1999, and around 2005/6, they cannot be easily distinguished from simple volume-related increases: if you see more deals, you will see more that will fail. What is perhaps most revealing is the very long time it takes for some deals to finally expire (see Figure 1.21). The clear modal year of failure in these large deals is year two to three, but there is a long tail that stretches out beyond the life of the original fund that made the investment. What Have Been the Biggest Deals in the World? Of the largest LBO bids ever made, nearly all took place at the height of the private equity boom that ended around July 2007 (Table 1.3). It is also notable that two of these bids did not complete. Another, Clear Channel, was only completed some two years after the initial agreement, following a legal dispute as the private equity backers placed pressure on the lenders to keep to their agreement to provide debt and negotiations to reduce the purchase price in the wake of the credit crisis. It is also interesting that two of the largest deals were completed in 2013. What Are the Largest Private Equity Funds in the World and Where Are They Based? An indication of the largest private equity funds in the world that lead new investments is given in Table 1.4. The table again illustrates the dominance of US and UK fund managers and the concentration of European private equity funds originating from the UK. Since the last edition of this book, the giant Japanese-managed tech fund Softbank and large state-owned investment funds in China have emerged. [0–1] 0 2 4 6 8 10 12 14 Largest UK Failures: Years to Failure Years to Failure Frequency [1–2] [2–3] [3–4] [4–5] [5–6] [6–7] [7–8] [8–9] [9–10] [10–11][11–12] >12 Figure 1.21. Largest UK private equity failures: time to failure Source: CMBOR/Investec/Equistone Partners Europe Downloaded from https://academic.oup.com/book/31976/chapter/267724321 by King's College London user on 22 October 2023.

[Audio] The Private Equity Market 37 How Significant Are Public-to-Private Transactions in the UK's Private Equity Market? Public company acquisitions by private equity funds ('public-to-privates', or 'P2Ps') have attracted much scrutiny and comment. We suggest that there is an overemphasis on P2Ps in the press and academic literature, due in no small part to a greater availability of data on public companies. Questions of insider dealing and the failure of corporate governance have been examined by a number of authorities in the UK and US. As seen above, around half of the largest UK buyouts by value have been P2Ps. A sustained period of activity, beginning around 1998, accelerated from 2004 culminating in the UK's largest Table 1.3. The world's largest buyouts Firm Deal date Deal size ($m) Investors Primary industry Energy Future Holdings Corporation 2007 45,000 California Public Employees' Retirement System (CalPERS), Citigroup, Energy Capital Partners, Goldman Sachs Merchant Banking Division, Kohlberg Kravis Roberts, Lehman Brothers, Morgan Stanley, Quintana Capital Group, TPG Energy Equity Office Properties Trust 2006 39,000 Blackstone Group Property HCA Holdings Inc. 2006 33,000 Bain Capital, Citigroup, Kohlberg Kravis Roberts, Merrill Lynch Global Private Equity, Ridgemont Equity Partners Healthcare First Data 2007 29,000 Citi Private Equity, Goldman Sachs Merchant Banking Division, Kohlberg Kravis Roberts Financial services H.J. Heinz Company 2013 28,000 3G Capital, Berkshire Hathaway Food Caesars Entertainment Corporation 2006 27,800 Apollo Global Management, Blackstone Group, California Public Employees' Retirement System (CalPERS), TPG Leisure Alltel Corporation 2007 27,500 Goldman Sachs Merchant Banking Division, TPG Telecommunications, media Hilton Worldwide 2007 26,000 Blackstone Group Leisure Dell Inc. 2013 24,900 MSD Capital, Silver Lake Hardware Clear Channel 2006 24,000 Bain Capital, Thomas H Lee Partners Advertising Source: Preqin. Downloaded from https://academic.oup.com/book/31976/chapter/267724321 by King's College London user on 22 October 2023.

[Audio] 38 Private Equity Demystified Table 1.4. Estimate of the world's largest private equity funds by value Fund Value (m) Vintage Strategy Fund manager Fund manager location SoftBank Vision Fund $98,583 2017 Hybrid SB Investment Advisers Japan China Integrated Circuit Industry Investment Fund II ¥200,000 2019 Growth SINO-IC Capital China Apollo Investment Fund IX $24,714 2018 Buyout Apollo Global Management US China Integrated Circuit Industry Investment Fund ¥138,700 2014 Growth SINO-IC Capital China Blackstone Capital Partners V $20,365 2006 Buyout Blackstone Group US GS Capital Partners VI $20,300 2007 Buyout Goldman Sachs Merchant Banking Division US China Structural Reform Fund ¥131,000 2016 Growth CCT Fund Management China TPG Partners VI $18,873 2008 Buyout TPG US Carlyle Partners VII $18,500 2018 Buyout Carlyle Group US CVC Capital Partners Fund VII €16,400 2018 Buyout CVC Capital Partners UK Apollo Investment Fund VIII $18,380 2014 Buyout Apollo Global Management US Blackstone Capital Partners VII $18,000 2016 Buyout Blackstone Group US Apax Europe VII €11,204 2007 Buyout Apax Partners UK Advent Global Private Equity IX $17,500 2019 Buyout Advent International US KKR Fund 2006 $17,267 2006 Buyout KKR US Hellman & Friedman Capital Partners IX $16,000 2018 Buyout Hellman & Friedman US TPG Partners V $15,372 2006 Buyout TPG US Blackstone Capital Partners VI $15,114 2011 Buyout Blackstone Group US Warburg Pincus Private Equity X $15,107 2007 Balanced Warburg Pincus US Warburg Pincus Global Growth $14,800 2018 Balanced Warburg Pincus US China State-Owned Capital Venture Fund I ¥102,000 2016 Venture China Reform Fund China Apollo Investment Fund VII $14,676 2008 Buyout Apollo Global Management US Silver Lake Partners V $14,500 2017 Buyout Silver Lake US CVC European Equity Partners V €10,750 2008 Buyout CVC Capital Partners UK Permira IV €11,100 2006 Buyout Permira UK Source: Preqin. Downloaded from https://academic.oup.com/book/31976/chapter/267724321 by King's College London user on 22 October 2023.

[Audio] The Private Equity Market 39 P2P transaction to date, Alliance Boots plc in 2007. However, as illustrated in Figure 1.22, P2Ps represent a relatively small proportion (by number) of the overall private equity market. At time of writing P2Ps have started to re-emerge after nearly a decade when they were less than 10 per cent of the market by value. They continue to be a small fraction of the number of transactions: this reflects changes to rules relating to public companies that increased the difficulty of executing such transactions. The rise in P2P transactions coincided with the top of the last cycle. Similar trends are seen in the USA. 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 10 20 30 %ge of PE deals Year 40 50 Share of deal numbers (%) Share of deal values (%) Figure 1.22. Percentage share of public to private buyouts by number and value (UK) 2004–13 Source: CMBOR/Investec/Equistone Partners Europe.