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Private equity is a broad term that commonly refers to any type of equity investment in an asset in which the equity is not freely
tradeable on a public stock market. More accurately, private equity refers to the manner in which the funds have been raised,
namely on the private markets, as opposed to the public markets. Private equity firms were commonly misunderstood to invest
in assets which were not in the public market. As we now know, larger private equity firms such as KKR, Blackstone, etc. invest in
companies listed on public exchanges and take them private. Passive institutional investors may invest in private equity funds,
which are in turn used by private equity firms for investment in target companies. Categories of private equity investment include
leveraged buyout, venture capital, growth capital, angel investing, mezzanine capital and others. Private equity funds typically
control management of the companies in which they invest, and often bring in new management teams that focus on making
the company more valuable.
As they are not listed on an exchange, a private equity firm owning such securities must find a buyer in the absence of a
traditional marketplace such as a stock exchange. The "exit" or "selling out" is often achieved by way of an initial public offering
(IPO), i.e. floating the company on a stock exchange, trade sale or secondary/tertiary buy-outs (i.e. sale to another private
equity house).
tradeable on a public stock market. More accurately, private equity refers to the manner in which the funds have been raised,
namely on the private markets, as opposed to the public markets. Private equity firms were commonly misunderstood to invest
in assets which were not in the public market. As we now know, larger private equity firms such as KKR, Blackstone, etc. invest in
companies listed on public exchanges and take them private. Passive institutional investors may invest in private equity funds,
which are in turn used by private equity firms for investment in target companies. Categories of private equity investment include
leveraged buyout, venture capital, growth capital, angel investing, mezzanine capital and others. Private equity funds typically
control management of the companies in which they invest, and often bring in new management teams that focus on making
the company more valuable.
As they are not listed on an exchange, a private equity firm owning such securities must find a buyer in the absence of a
traditional marketplace such as a stock exchange. The "exit" or "selling out" is often achieved by way of an initial public offering
(IPO), i.e. floating the company on a stock exchange, trade sale or secondary/tertiary buy-outs (i.e. sale to another private
equity house).
| DEFINITIONS |
Private equity funds are the pools of capital invested by private equity firms. Although other structures exist, private equity
funds are generally organized as either a limited partnership or limited liability company which is controlled by the private equity
firm that acts as the general partner. The limited partnership is often called the "Fund", and the general partners are sometimes
designated as the "Management Company" (although at times, that is a separate company affiliated with the general partner).
The fund obtains capital commitments from certain qualified investors such as pension funds, financial institutions and wealthy
individuals to invest a specified amount. These investors become passive limited partners in the fund partnership and at such
time as the general partner identifies an appropriate investment opportunity, it is entitled to "call" the required equity capital at
which time each limited partner funds a pro rata portion of its commitment. All investment decisions are made by the General
Partner which also manages the fund's investments (commonly referred to as the "portfolio"). Over the life of a fund which often
extends up to ten years, the fund will typically make between 15 and 25 separate investments with usually no single investment
exceeding 10% of the total commitments.
General partners are typically compensated with a combination of a management fee (defined as a percentage of the fund's
total equity capital), monitoring fees (fees paid to the general partner by portfolio companies for services), as well as transaction
fees (fees paid to the general partner in their M&A advisory capacity). In addition, the general partner usually is entitled to
"carried interest", effectively a performance fee, based on the profits generated by the fund. Typically, the general partner will
receive an annual management fee of 1% to 2% of committed capital and carried interest of 20% of profits above some target
rate of return, which is typically 8% to 10% (called "hurdle rate"). Gross private equity returns may be in excess of 20% per year,
which in the case of leveraged buyout firms is primarily due to increasing levels of leverage in the portfolio companies, and
otherwise due to the high level of risk associated with early stage investments. Although there is a limited market for limited
partnership interests, such interests are not as freely tradeable like mutual fund interests.
Private equity firms generally receive a return on their investment through one of three ways: an IPO, a sale or merger of the
company they control, or a recapitalization. Unlisted securities may be sold directly to investors by the company (called a private
offering) or to a private equity fund, which pools contributions from smaller investors to create a capital pool.
Considerations for investing in private equity funds relative to other forms of investment include:
Substantial entry costs, with most private equity funds requiring significant initial investment (usually upwards of $100,000) plus
further investment for the first few years of the fund called a 'drawdown'.
Investments in limited partnership interests (which is the dominant legal form of private equity investments) are referred to as
"illiquid" investments which should earn a premium over traditional securities, such as stocks and bonds. Once invested, it is
very difficult to gain access to your money as it is locked-up in long-term investments which can last for as long as twelve years.
Distributions are made only as investments are converted to cash; limited partners typically have no right to demand that sales
be made.
If the private equity firm can't find good investment opportunities, they will not draw on our commitment. Given the risks
associated with private equity investments, you can lose all your money if the private-equity fund invests in failing companies.
The risk of loss of capital is typically higher in venture capital funds, which back young companies in the earliest phases of their
development, and lower in mezzanine capital funds, which provide interim investments to companies which have already proven
their viability but have yet to raise money from public markets.
Consistent with the risks outlined above, private equity can provide high returns, with the best private equity managers
significantly outperforming the public markets.
For the above mentioned reasons, private equity fund investment is for those who can afford to have their capital locked in for
long periods of time and who are able to risk losing significant amounts of money. This is balanced by the potential benefits of
annual returns which range up to 30% for successful funds.
Most private equity funds are offered only to institutional investors and individuals of substantial net worth. This is often required
by the law as well, since private equity funds are generally less regulated than ordinary mutual funds. For example in the US,
most funds require potential investors to qualify as accredited investors, which requires $1 million of net worth, $200,000 of
individual income, or $300,000 of joint income (with spouse) for two documented years and an expectation that such income
level will continue.
Some examples of private equity owned organisations are the AA (a major UK motoring organisation) and Jimmy Choo
(high-end ladies shoes).
funds are generally organized as either a limited partnership or limited liability company which is controlled by the private equity
firm that acts as the general partner. The limited partnership is often called the "Fund", and the general partners are sometimes
designated as the "Management Company" (although at times, that is a separate company affiliated with the general partner).
The fund obtains capital commitments from certain qualified investors such as pension funds, financial institutions and wealthy
individuals to invest a specified amount. These investors become passive limited partners in the fund partnership and at such
time as the general partner identifies an appropriate investment opportunity, it is entitled to "call" the required equity capital at
which time each limited partner funds a pro rata portion of its commitment. All investment decisions are made by the General
Partner which also manages the fund's investments (commonly referred to as the "portfolio"). Over the life of a fund which often
extends up to ten years, the fund will typically make between 15 and 25 separate investments with usually no single investment
exceeding 10% of the total commitments.
General partners are typically compensated with a combination of a management fee (defined as a percentage of the fund's
total equity capital), monitoring fees (fees paid to the general partner by portfolio companies for services), as well as transaction
fees (fees paid to the general partner in their M&A advisory capacity). In addition, the general partner usually is entitled to
"carried interest", effectively a performance fee, based on the profits generated by the fund. Typically, the general partner will
receive an annual management fee of 1% to 2% of committed capital and carried interest of 20% of profits above some target
rate of return, which is typically 8% to 10% (called "hurdle rate"). Gross private equity returns may be in excess of 20% per year,
which in the case of leveraged buyout firms is primarily due to increasing levels of leverage in the portfolio companies, and
otherwise due to the high level of risk associated with early stage investments. Although there is a limited market for limited
partnership interests, such interests are not as freely tradeable like mutual fund interests.
Private equity firms generally receive a return on their investment through one of three ways: an IPO, a sale or merger of the
company they control, or a recapitalization. Unlisted securities may be sold directly to investors by the company (called a private
offering) or to a private equity fund, which pools contributions from smaller investors to create a capital pool.
Considerations for investing in private equity funds relative to other forms of investment include:
Substantial entry costs, with most private equity funds requiring significant initial investment (usually upwards of $100,000) plus
further investment for the first few years of the fund called a 'drawdown'.
Investments in limited partnership interests (which is the dominant legal form of private equity investments) are referred to as
"illiquid" investments which should earn a premium over traditional securities, such as stocks and bonds. Once invested, it is
very difficult to gain access to your money as it is locked-up in long-term investments which can last for as long as twelve years.
Distributions are made only as investments are converted to cash; limited partners typically have no right to demand that sales
be made.
If the private equity firm can't find good investment opportunities, they will not draw on our commitment. Given the risks
associated with private equity investments, you can lose all your money if the private-equity fund invests in failing companies.
The risk of loss of capital is typically higher in venture capital funds, which back young companies in the earliest phases of their
development, and lower in mezzanine capital funds, which provide interim investments to companies which have already proven
their viability but have yet to raise money from public markets.
Consistent with the risks outlined above, private equity can provide high returns, with the best private equity managers
significantly outperforming the public markets.
For the above mentioned reasons, private equity fund investment is for those who can afford to have their capital locked in for
long periods of time and who are able to risk losing significant amounts of money. This is balanced by the potential benefits of
annual returns which range up to 30% for successful funds.
Most private equity funds are offered only to institutional investors and individuals of substantial net worth. This is often required
by the law as well, since private equity funds are generally less regulated than ordinary mutual funds. For example in the US,
most funds require potential investors to qualify as accredited investors, which requires $1 million of net worth, $200,000 of
individual income, or $300,000 of joint income (with spouse) for two documented years and an expectation that such income
level will continue.
Some examples of private equity owned organisations are the AA (a major UK motoring organisation) and Jimmy Choo
(high-end ladies shoes).
A leveraged buyout (or LBO, or highly-leveraged transaction (HLT), or "bootstrap" transaction) occurs when a financial sponsor
gains control of a majority of a target company's equity through the use of borrowed money or debt.
A leveraged buyout is a strategy involving the acquisition of another company using a significant amount of borrowed money
(bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the
loans, in addition to the assets of the acquiring company. The purpose of leveraged buyouts is to allow companies to make
large acquisitions without having to commit a lot of capital. In a LBO, there is usually a ratio of 70% debt to 30% equity,
although debt can reach as high as 90% to 95% of the target company's total capitalization. The equity component of the
purchase price is typically provided by a pool of private equity capital.
Typically, the loan capital is borrowed through a combination of prepayable bank facilities and/or public or privately placed
bonds, which may be classified as high-yield debt, also called junk bonds. Often, the debt will appear on the acquired company's
balance sheet and the acquired company's free cash flow will be used to repay the debt.
gains control of a majority of a target company's equity through the use of borrowed money or debt.
A leveraged buyout is a strategy involving the acquisition of another company using a significant amount of borrowed money
(bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the
loans, in addition to the assets of the acquiring company. The purpose of leveraged buyouts is to allow companies to make
large acquisitions without having to commit a lot of capital. In a LBO, there is usually a ratio of 70% debt to 30% equity,
although debt can reach as high as 90% to 95% of the target company's total capitalization. The equity component of the
purchase price is typically provided by a pool of private equity capital.
Typically, the loan capital is borrowed through a combination of prepayable bank facilities and/or public or privately placed
bonds, which may be classified as high-yield debt, also called junk bonds. Often, the debt will appear on the acquired company's
balance sheet and the acquired company's free cash flow will be used to repay the debt.
Venture capital is a type of private equity capital typically provided by professional, institutionally-backed outside investors to
new, growth businesses. Generally made as cash in exchange for shares in the investee company, venture capital investments
are usually high risk, but offer the potential for above-average returns. A venture capitalist (VC) is a person who makes such
investments. A venture capital fund is a pooled investment vehicle (often a partnership) that primarily invests the financial
capital of third-party investors in enterprises that are too risky for the standard capital markets or bank loans. In China, venture
funding more than doubled from $420 thousand in 2002 to almost $1 million in 2003. For the first half of 2004, venture capital
investment rose 32% from 2003. By 2005, lead by a wave of successful IPOs on the NASDAQ and revised government
regulations, China-dedicated funds raised US$4 million in committed capital
new, growth businesses. Generally made as cash in exchange for shares in the investee company, venture capital investments
are usually high risk, but offer the potential for above-average returns. A venture capitalist (VC) is a person who makes such
investments. A venture capital fund is a pooled investment vehicle (often a partnership) that primarily invests the financial
capital of third-party investors in enterprises that are too risky for the standard capital markets or bank loans. In China, venture
funding more than doubled from $420 thousand in 2002 to almost $1 million in 2003. For the first half of 2004, venture capital
investment rose 32% from 2003. By 2005, lead by a wave of successful IPOs on the NASDAQ and revised government
regulations, China-dedicated funds raised US$4 million in committed capital
Growth capital is a very flexible type of financing. The money borrowed under a growth capital line of credit can be used for any
corporate purposes. There are no requirements to provide invoices or other backup material when borrowing under this type of
facility, so administration is simplified as well.
Growth capital can be a beneficial way to extend a company’s runway between rounds of financing. The extra time can be used to
complete additional milestones that will raise the company’s valuation, or as insurance to ensure that all intended milestones
are successfully accomplished.
corporate purposes. There are no requirements to provide invoices or other backup material when borrowing under this type of
facility, so administration is simplified as well.
Growth capital can be a beneficial way to extend a company’s runway between rounds of financing. The extra time can be used to
complete additional milestones that will raise the company’s valuation, or as insurance to ensure that all intended milestones
are successfully accomplished.
Mezzanine capital (or mezzanine debt) is a broad financial term that refers to unsecured, high-yield, subordinated debt or
preferred stock that represents a claim on a company's assets that is senior only to that of a company's shareholders.Along with
the typical interest payment associated with debt, mezzanine capital will often include an equity stake in the form of warrants
attached to the debt obligation or a debt conversion feature identical to that of a convertible bond.
Mezzanine capital is a more expensive financing source for a company than secured debt or senior debt. It is more expensive
because of the increased credit risk, i.e. in the event of default, mezzanine debt is less likely to be repaid in full. It is only
secured by the equity of the company, and not the company's tangible assets (e.g., property, cash or accounts receivable). In
compensation for the increased risk, mezzanine debt holders will require a higher interest payment or an equity stake in the
company. However, it is a cheaper source of financing than equity as the current equity holders achieve less dilution.
preferred stock that represents a claim on a company's assets that is senior only to that of a company's shareholders.Along with
the typical interest payment associated with debt, mezzanine capital will often include an equity stake in the form of warrants
attached to the debt obligation or a debt conversion feature identical to that of a convertible bond.
Mezzanine capital is a more expensive financing source for a company than secured debt or senior debt. It is more expensive
because of the increased credit risk, i.e. in the event of default, mezzanine debt is less likely to be repaid in full. It is only
secured by the equity of the company, and not the company's tangible assets (e.g., property, cash or accounts receivable). In
compensation for the increased risk, mezzanine debt holders will require a higher interest payment or an equity stake in the
company. However, it is a cheaper source of financing than equity as the current equity holders achieve less dilution.
A convertible bond is a type of bond that can be converted into shares of stock in the issuing company, usually at some
pre-announced ratio. Although it typically has a low coupon rate, the holder is compensated with the ability to convert the bond
to common stock, usually at a substantial premium to the stock's market value.
Other convertible securities include exchangeable bonds, where the stock underlying the bond is different from that of the
issuer; convertible preferred stock, which is similar in valuation to a bond, but with lower seniority in the capital structure; and
mandatory convertible securities, which are short duration securities---generally with high yields---that are mandatorily
convertible upon maturity into a variable number of common shares based on the stock price at maturity.
From the issuer's perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment.
However, in exchange for the benefit of reduced interest payments, the value of shareholder's equity is reduced due to the
dilution expected when bondholders convert their bonds into new shares.
From a valuation perspective, a convertible bond consists of two assets: a bond and a warrant. Valuing a convertible requires an
assumption of 1) the underlying stock volatility to value the option and 2) the credit spread for the fixed income portion that
takes into account the firm's credit profile and the ranking of the convertible within the capital structure. Using the market price
of the convertible, one can determine the implied volatility (using the assumed spread) or implied spread (using the assumed
volatility).
This volatility/credit dichotomy is the standard practice for valuing convertibles. What makes convertibles so interesting is that,
except in the case of exchangeables (see above), one cannot entirely separate the volatility from the credit. Higher volatility (a
good thing) tends to accompany weaker credit (bad). The true artists of convertibles are the people who know how to play this
balancing act.
A simple method for calculating the value of a convertible involves calculating the present value of future interest and principal
payments at the cost of debt and adds the present value of the warrant. However, this method ignores certain market realities
including stochastic interest rates and credit spreads, and does not take into account popular convertible features such as issuer
calls, investor puts, and conversion rate resets. The most popular models for valuing convertibles with these features are finite
difference models such as binomial and trinomial trees.
pre-announced ratio. Although it typically has a low coupon rate, the holder is compensated with the ability to convert the bond
to common stock, usually at a substantial premium to the stock's market value.
Other convertible securities include exchangeable bonds, where the stock underlying the bond is different from that of the
issuer; convertible preferred stock, which is similar in valuation to a bond, but with lower seniority in the capital structure; and
mandatory convertible securities, which are short duration securities---generally with high yields---that are mandatorily
convertible upon maturity into a variable number of common shares based on the stock price at maturity.
From the issuer's perspective, the key benefit of raising money by selling convertible bonds is a reduced cash interest payment.
However, in exchange for the benefit of reduced interest payments, the value of shareholder's equity is reduced due to the
dilution expected when bondholders convert their bonds into new shares.
From a valuation perspective, a convertible bond consists of two assets: a bond and a warrant. Valuing a convertible requires an
assumption of 1) the underlying stock volatility to value the option and 2) the credit spread for the fixed income portion that
takes into account the firm's credit profile and the ranking of the convertible within the capital structure. Using the market price
of the convertible, one can determine the implied volatility (using the assumed spread) or implied spread (using the assumed
volatility).
This volatility/credit dichotomy is the standard practice for valuing convertibles. What makes convertibles so interesting is that,
except in the case of exchangeables (see above), one cannot entirely separate the volatility from the credit. Higher volatility (a
good thing) tends to accompany weaker credit (bad). The true artists of convertibles are the people who know how to play this
balancing act.
A simple method for calculating the value of a convertible involves calculating the present value of future interest and principal
payments at the cost of debt and adds the present value of the warrant. However, this method ignores certain market realities
including stochastic interest rates and credit spreads, and does not take into account popular convertible features such as issuer
calls, investor puts, and conversion rate resets. The most popular models for valuing convertibles with these features are finite
difference models such as binomial and trinomial trees.
Senior debt refers to debt secured by collateral on which the lender has put in place a first lien. Usually this covers all the assets
of a corporation and is often used for revolving credit lines. It is the debt that has priority for repayment in a liquidation.
It is a class of corporate debt that has priority with respect to interest and principal over other classes of debt and over all
classes of equity by the same issuer
of a corporation and is often used for revolving credit lines. It is the debt that has priority for repayment in a liquidation.
It is a class of corporate debt that has priority with respect to interest and principal over other classes of debt and over all
classes of equity by the same issuer
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