It is more than one year since I have been blogging about basics of private equity. During that time, I went through a path of ups and down to realize one more time that private equity and venture capital are my passion; I have decided to move my carrier plan into entrepreneurial direction, and from now on I will be writing about private equity and venture capital from a portfolio management point of view.
Why have I decided to be an entrepreneur? I pursued a classic career path in management consulting until finally I have earned my MBA. I always wanted to be an entrepreneur. I have been waiting for the right moment and finally this moment has arrived. I am building my own business from scratches. I leverage my consulting experience, education and the experience in US to run a career focused on helping companies to grow by penetrating the US market.
Does it means that PElosophy will change? Somehow yes, because I will be posting articles about ‘how to growth your business’, written from a private equity and venture capital point of view.
I hope that you will stay with me! More news about my projects coming soon, also useful tips and additional information.
PElosophy is mainly a PE blog; however, thanks to the cooperation with Accredited Investor Markets and Alicia Purdy who writes about all asset class, together we have written the article “The Fine Print for Investing in Hedge Funds.”
This article is for all of you who consider to invest in hedge funds or are interested how hedge funds operate.
The Fine Print on Investing in Venture Capital a must to read article for all those of you who are thinking about investing in venture capital.
The article was prepared by Accredited Investors Markets in cooperation with PElosophy.
Barack Obama signed the Jumpstart Our Business Startups Act (JOBS Act) on April 5, 2012. The JOBS Act has introduced the most significant changes to private investing since 1933. It allows companies, especially small and medium sized enterprises, easier access to capital. Let’s take a close look at those changes.
Title I of the JOBS Act introduced the definition of emerging growth companies (EGCs). According to the Securities and Exchange Commission (SEC), an ECG is “an issuer with total annual gross revenues of less than $1 billion during its most recently completed fiscal year”*. Additionally, it has loosened restrictions on those companies in terms of the initial public offer (IPO) process. Title II has abolished the ban of general advertising of securities; however, still only accredited investors have the right to buy those securities directly. Title III has established a crowdfunding platform mechanism to raise capital from non-accredited investors. More details concerning the JOBS Act can be found here.
But, what does this all mean in practice?
First of all, the JOBS Act has enabled ECGs to raise capital through crowd funding platforms or through IPOs. Due to the financial crises, banks are more cautious about lending money. Additionally, for small businesses, banks have never been the primary source of capital. In recent years, we can also observe a decrease in the number of IPOs (down 25% in comparison to 10 years ago and 40% from the peak in 1997*). The JOBS Act is supposed to reverse that trend.
Secondly, the JOBS Act has loosened restrictions related to advertising and investment services. As a result, accredited investors have now become the main target of advertising campaigns. Beyond this, investors are no longer bound by the obligation to conduct securities transitions through brokers and dealers. The Act has allowed accredited investors to become independent investors and conduct transactions on their own.
Thirdly, the Act also impacts non-accredited investors. Though non-accredited investors are still unable to invest without brokers and dealers, the JOBS Act allows them to conduct direct investments via crowd funding portals.
In order to put the JOBS Act into practice, the SEC needs to establish transparent guidelines for the implementation of these changes. Unfortunately, the Commission has yet to officially establish the rules and regulations concerning Title II and Title III. As a result, the complete implementation of the JOBS Act has not come to fruition.
Before the introduction of the JOBS Act, portals such as Kickstarter, Indiegogo and Crowdfunder created in increase in independently generated capital. Currently, the new legislation aims to boost this sector. To ensure continued growth, it is imperative that investors are able to make educated investment choices as independent entities.
PElosophy is proud to announce the collaboration with Accredited Investor Markets! The Accredited Investor Markets is the most reliable source of fundamentals, news analysis, and resources about investing in private equity, venture capital, hedge funds, tangible assets, and pre-IPO shares.
Enjoy and more article coming soon!
The process of approaching portfolio companies starts long before the deal is made. Although private equity firms have different ways of approaching portfolio companies, the following steps highlight the most common:
The research phase is closely connected with the diversification policy of each PE firm and the investment policy included in the Limited Partnership Agreement (LPA). Diversification is made in the following areas:
- Size of the company measured by EBITA, revenue or value of assets under management
- Geography e.g. located in one or more region, country or pan-continental
- Industry e.g. Healthcare, Infrastructure, Energy
- Transaction type e.g. sole management buyout or mix of buyouts and growth capital
Based on chosen diversification criteria, PE firms decide on a short list of companies to approach. The final step of this phase is to start the direct negotiation with the chosen companies and collect sufficient the data to expedite the process.
2. Due Diligence
To make the final decision about buying a company, PE firms conduct due diligence. Due diligence (DD) is executed by another entity (external consultant or buying company) in order to investigate and confirm all of the information that has been gathered about the acquired company. An outline of the main components of DD is: legal, financial, management/organizational, IT, marketing, products/ services, and tax. The outcome of DD has a direct influence on the success or failure of the transaction.
Transaction refers to the finalization stage of acquiring a company, which is when PE firms become a formal owner. It can be conducted in two ways: buying shares from the market or buying a company from its owners.
4. Imposing Strategies
Strategies can be divided into two groups. The first group concerns the level of debt from the transaction. PE firms must assure that portfolio companies will be able to repay their debt. The second group concerns improving the governance of the portfolio companies. This phase formally begins after the transaction; however, most PE firms start this phase during due diligence. Choosing strategies depends on the condition of the company. This choice is based on internal PE operational and financial knowledge and supported by the expertise of local or international management consulting companies and individual experts. Where as the first group of strategies concerns mostly financial engineering and cost cutting, the second may concern entering a new market, launching new products or focusing on operational improvements. This phase can last anywhere from six months to one year.
The task of the monitoring is to ensure that imposed strategies are yielding the required results. Monitoring is conducted routinely, usually monthly or quarterly, to examine the measurements that have been implemented. Monitoring is a key process in terms of strategic decision-making. Details about monitoring measurements are described in the post Measurements to Evaluate Portfolio Companies’ Performance.
The goal of the exit is to receive a return from the investment. PE firms exit an investment when the conditions are most profitable. Factors such as the stability of the company, the success of imposed strategies, and ideal external conditions influence how this final stage is executed.
In terms of the relation between PE firms and portfolio companies, the main questions concern the level of control PE firms has over portfolio companies, the source of growth of portfolio companies and, finally, whether PE firms add significant value to portfolio companies.
PE firms, even before the transaction is closed, have a clear vision of how a portfolio company should be managed. Having the majority of votes, PE firms possess enough control to force portfolio companies to implement their strategies. PE firms believe that they understand the company better than the current managers and, as a result, they are able to more accurately assess risks. This confidence manifests in two ways, or rather, on both side of the balance sheet.
In terms of right side, it allows PE firms to take great risks and borrow more money than the companies they acquire would normally do. This money is used to finalize the transaction. According to PE firms, a high level of debt brings two major advantages. One concerns tax benefits, high interest rates yield tax reduction. Secondly, high debt demands great efficiency and commitment from managers. This risk is taken not only by the portfolio company, but also by the investors and, in extreme circumstances, taxes payers.
In terms of left side of the balance sheet, PE firms are confident that they can run chosen companies better. PE firms prepare themselves, at a very early stage, to assess the possibilities of growth in the industry and the company. They work both internally and externally to evaluate this growth. This hands-on management approach is supposed to bring the profitable return.
Do PE firms always focus on both sides of the balance sheet? The answer is no. This is evident in the shift from financial engineering towards operational engineering. Almost all PE firms use words like “add value” or “growth” as marketing tools. Worth mentioning are: Blackstone “We play a vital role in providing businesses with the capital to realize their growth potential. We uncover value by identifying great companies and enhancing their performance by providing patient capital and partnering with strong management teams”, KKR “Our approach is to combine our platform of global resources with our industry knowledge and operational expertise to help improve our portfolio companies over the long-term. Central to this approach is our belief that the private equity model can be a powerful catalyst for improving companies”. On its website, The Private Equity Growth Capital Council states: “Some suggest that private equity delivers its substantial returns mainly as a result of financial engineering and does little to create real-world value. In its early years, private equity firms could simply change a firm’s capital structure and make considerable profits. But that is no longer the case.”
While searching for data to back up claims about adding value to portfolio companies, the study “Corporate Governance and Value Creation: Evidence from Private Equity” done by Viral Acharya, Moritz Hahn and Conor Kehoe offered some insight. They examined 110 completed private equity deals made in the UK and Europe between 1995 and 2005. They calculated an average IRR on these deals of 38.6%. Most of the return came from a combination of the stock market (8.5%) and debt (21.7%); the rest (8.4%) came from private equity’s specific contribution.  As a result, we can conclude that 78% of returns come from debt and market conditions and only 22% is operational engineering.
Based on the information collected, private equity investments should be a win-win situation for both sides. PE firms bring their expertise to boost the growth of the company and, as a result, investors receive a superior return. Although this is the prevailing message, there is not adequate research and data available to confirm it.
 Page 26. Peter Morris. 2010. Private Equity, Public Loss? The Centre for the Study of Financial Innovation
Monitoring of a portfolio companies’ performance is the most important activity in terms of guarantying company growth and a profitable return from the exit. Through constant supervision, PE firms ensure that a company realizes the imposed targets. In line with setting up the model of cooperation and imposed strategies, PE firms establish measurements to evaluate the progress of the company. We can distinguish two main types of measurements: financial and operational. Additionally, some PE firms also measure the added value they have created after entering the company.
Financial measurements focus on evaluating the financial gains generated by the implementation of a PE firms imposed strategies. These measurements are common for all PE firms and are based on the evaluation and assessment of a company’s financial statements. The table below briefly summarizes the most important of these.
|EBITDA||Net income before interest rate, taxes, depreciation and amortization. EBITDA shows company’s performance excluding the influence of company’s finance and accounting strategy.|
|Revenue / sales||During the first years all the revenue is reinvested or used to repay the debt from the transaction; as a result their level has to be constantly monitored.|
|Cash flow||Cash flow shows the company’s cash dynamics (in and out) in given period. It reflects the company’s capability to repay its debt.|
|Costs||As cost reduction is one of the main PE imposed strategies, costs are one of the main financial measurements.|
|Net Debt||In most cases, the transaction is financed by debts; as a result their level has to be constantly monitored.|
Operational measurements are associated with the implementation of projects in accordance with the imposed strategies. They differ depending on the industry, specific company features, and the project type. To illustrate their variety, several are presented below:
- Telecom – cost/ # of phone lines, cost/ # of clients
- Energy – cost/ output in kilowatt-hours, # of blackouts/ week, cost/ # of clients
- Healthcare – cost/ # of beds, # of patients/ month
Added Value Measurements
The goal of this measurement is to present how much value a PE firm adds to a portfolio company in terms of its organic growth. This type of measurement is not common for all PE firms. Consequently, there is no a common approach to measure it. We can distinguished the following:
- Like for like growth is a measure of growth in sales, adjusted for new or divested businesses.*
- PE firm value creation formula that calculates organic growth at the exit
All of these measurements together, plus the valuation model of the company and the return from investment measurements (Internal Rate of Return (IRR) and the realization multiple), create a complete model for constant monitoring and evaluation. This model functions to offer a checks and balances system between PE firms and portfolio companies.
The model of cooperation with portfolio companies establishes the basic framework for collaboration with PE firms. It comes into play during the finalization of the transaction. Each PE firm has their own model of cooperation with portfolio companies. Generally, this relationship can be viewed as three levels.
A model of cooperation supports organization change and decision concerning employ management. The goal of this model is to guarantee cooperation, control, and communication. Without a model of cooperation, PE firms would have little or no influence on portfolio companies.
I. Board of Directors
A Board of directors consists of members chosen from within the company and from outside the company. The internal members are the top members of the management team and the external members are independent experts. Typically, internal board members are the CEO and CFO (see II. Management Team). In terms of external experts, there are two types. The first type is PE firm professionals who provide hands-on management. In most cases, they are long-standing company affiliates who took part in the transaction. Their task is to control strategy implementation and offer advice and assistance. The second type is experts that bring unique and specified industry experience. Typically they are former CEOs from other industry companies who have led their organization through changes. On the global stage, it is not uncommon for these experts to be international. Their task is to provide guidelines concerning the direction of change.
II. Management Team and External Consultants
The management team is responsible for day-to-day management of a company. As a result, management team members should be from the top of their industry. Depending on the model of cooperation and the company’s condition, a PE firm can change any or all members of the existing management team. Indefinitely, the chosen leaders must have adequate background ,which will enable them to oversee a company’s transformation. As such, PE firms use discretion when making managerial changes.
The role of external consultants is to provide strategic and operational expertise concerning the improvement of a portfolio company. We can distinguish two types of expertise. One provides a complex consultation related to potential areas of improvement in terms of products (i.e. new products, fewer products), markets (i.e. old products to new markets), pricing and positioning, efficiency (i.e., restructuring, cost cutting) or assets. This type of consulting is typically provided during the first year. The other type of expertise concerns specific questions asked by the portfolio company or PE firm. This type of consulting is provided through out all stages of transformation. Some PE firms only hire consultants from well-established, reputable management consulting companies. Some only hire area-based experts with local knowledge. Sometime it is mixture of both which allows the company to gather the highest quality of information from multiple perspectives.
The committee is an internal body that consists of middle management employees from the portfolio company. Their role is to supervise project implementation in accordance with the PE firm imposed strategies. They can also take on the role of identifying internal discrepancies and proposing ideas for improvement. The number of committees depends on the PE firm’s model of cooperation. Some committees address a broader scope or agenda where as others focus on specific areas. The head of committee is usually a member of the management team. Because of their status within the company, their presence increases motivation and productivity within committee.