PRIVATE EQUITY Viney Sawhney Introduction – Course Description This course is the study of private equity money invested in companies that are not publicly traded on a stock exchange or invested in as part of buyouts of publicly traded companies. The objective of the course is to provide an introduction and general understanding of the private equity markets. Private equity finance will be explored from a number of perspectives, beginning with the structure and objectives of private equity funds; followed by the analysis and financing of investment opportunities; and finally crafting harvesting strategies for investments. There has been an increase in both the supply of and demand for private equity. On the supply side, the amount of private equity under management - by partnerships investing in private equity, growth investments, leveraged buyouts, distressed companies, real estate, etc. - has increased dramatically in recent years. On the demand side, an increasing number of individuals and companies are interested in starting and growing their respective businesses. Collectively, small and medium businesses are focused in gaining access to Private Equity and understanding the dynamics of this unique funding source. Course objectives The main objective of the course is to provide students with the necessary theoretical and conceptual tools used in private equity deals. The course provides the intellectual framework used in the private equity process, valuation in private equity settings, creating term sheets, the process of due diligence and deal structuring. Other learning objectives include building an understanding of harvesting through IPO or M&A, public-private partnerships and sovereign wealth funds. The final objective of this course is to show how corporate governance, ethics and legal considerations factor into private equity deals. Appropriate for Students Pursuing: This course is appropriate for students pursuing a career in private equity and for students who wish to broaden their understanding of finance by applying financial concepts and techniques to analyze activities and enterprises in the private equity market. Main Topics 1) Private Equity Process 2) Valuation and Term Sheets 3) Deal Structuring 4) Harvesting 5) Due Diligence 6) Public-Private Partnerships 7) Sovereign Wealth Funds 8) Legal, Ethical and Governance Issues in Private Equity Settings
Course Evaluation The grading of the course will be based on the following weighting scheme: Class Participation: 25%, Mid-term Group Presentation: 20%, Final Group Case Presentation: 30%, Homework 25%.
The course will be taught in the form of lectures together with case studies intended for in class discussion. Each student will be part of a study group made up of at least three members. Weighting for class participation will be derived from individual assignments and class discussion on case studies. Teaching Method This course will have a number of different dimensions including: • Lectures • Case Analysis • Guest speakers from industry and academia • Group Presentations Course Textbooks Demaria, Cyril, Introduction to Private Equity, John Wiley & Sons (New York, NY, 2010) Cendrowski, Harry, Martin, James P., Petro, Louis W., and Wadecki, Adam A, Private Equity, History, Governance, and Operations, John Wiley & Sons (New York, NY, 2008) Lerner, Josh, Hardymon, Felda, and Leamon, Ann., Venture Capital and Private Equity: A Casebook, Fourth Edition, John Wiley & Sons (New York, NY, 2008)
SCHEDULE Session 1: THE FUNDAMENTALS OF PRIVATE EQUITY This session provides an overview of the private equity concept, the actors and the terminology. Merits of private equity, limited partners – the investors and the general partner, agreements between investors and partners, private equity markets and the growing significance of private equity funds are introduced. Asset allocation, the choices of investment funds and the types of private equity portfolio activities will also be examined. Required Reading: Demaria, Cyril, Introduction to Private Equity, John Wiley & Sons (New York, NY, 2010), Chs. 1 & 2. A Note on Private Equity Partnership Agreements, 1994, HBS publication 9-294-084 Case: “Yale University Investments Office: August 2006,” 2007, HBS Case # 9-807-073 The Yale Investments Office must decide whether to continue to allocate the bulk of the university's endowment to illiquid investments--hedge funds, private equity, real estate, and so forth. This case considers the risks and benefits of a different asset allocation strategy and highlights the choice between different subclasses, e.g., between venture capital and leveraged buyout funds. Session 2:THE PRIVATE EQUITY PROCESS This session introduces the private equity process, the terms and how value is created. This session covers the private equity process from initially determining the size of the fund, through fund raising, sourcing portfolio investments, acquiring the portfolio companies and converting equity value back to cash by liquidating portfolio holdings. The means by which private equity firms create value and enhance the valuation of their portfolio is also covered. Required Reading: Cendrowski, Harry, Martin, James P., Petro, Louis W., and Wadecki, Adam A, Private Equity, History, Governance, and Operations, John Wiley & Sons (New York, NY, 2008), Ch 1 A Note on Private Equity Fund-Raising, 2000, HBS Publication # 9-201-042 Case: “Gobi Partners: Raising Fund II,” 2007, HBS Case #9-807-093. The three founding partners of Gobi Partners, a venture capital fund investing in early start IT and digital media companies in China, are planning to raise a second fund. The first $51.75 million fund is close to being entirely invested and the portfolio companies are doing well, with two having raised subsequent financings at significantly increased valuations. The firm itself has increased its headcount and opened a second office, but it has not, however, exited any of its companies. How much money should the partners hope to raise, and from whom? The stakes are high, as none of them has taken a paycheck in three years.
Session 3: THE PROCESS OF INVESTMENT As private equity firms identify potential portfolio companies, they work through a process to acquire the target companies. This session is devoted to the process of investment: preliminary analysis, valuation, negotiating, structuring and performing due diligence and executing an agreement. This session also examines the primary securities used in private equity, their structures, and the economic motivation behind their designs. Required Reading: Demaria, Cyril, Introduction to Private Equity, John Wiley & Sons (New York, NY, 2010), Ch. 5 A Note on Private Equity Securities, 1999, HBS Publication # 9-200-027 Case: “Hertz Corporation (A) and (B),” 2007, HBS Case #9-208-030. Examines the leveraged buyout of Hertz in 2005, a complex, high-profile deal and a good example of cutting-edge practice in private equity. The first of a two-part series on the Hertz LBO, adopts the perspective of Clayton, Dubilier & Rice, the leader of a private equity consortium bidding to buy Hertz from Ford in an auction. Set at the final round of the auction, the immediate problem for the consortium is how much to raise its previous bid. A reasonable bid must be based upon how much value the private equity consortium can create through improvements in Hertz's global operations on the one hand, and a more efficient capital structure on the other. Session 4: VALUATION TECHNIQUES AND TERM SHEETS This session covers deal dynamics, expected returns, term sheets, valuation and leveraged buyouts. Also examined is the term sheet, its use as the framework for negotiations between investors and entrepreneurs and the conditions under which investors agree to provide financing. This session addresses ways in which venture-backed firms can be valued, including net present value and comparables. Required Reading: A Note on Valuation in Private Equity Settings, 1996, HBS Publication # 9-297-050 Technical Note on LBO Valuation (A), 2001, HBS Case # 9-902-004 Technical Note on LBO Valuation (B), 2001, HBS Case # 9-902-005 Case: “Lion Capital and the Blackstone Group: The Orangina Deal,” 2005, HBS Case# 9-807-005. The managing partners of two private equity firms are hoping to forestall a third bidding round for a target company, the European beverage division of Cadbury Schweppes. As they wait to meet with the CEO, they revisit their assumptions on the deal and review the insights that informed their valuation. Session 5: DEAL STRUCTURING This session is devoted to deal structuring, management’s incentive, investors’ conditions and aligning stakeholders’ interests to negotiate deals that are satisfactory to both sides. Different deal structures, each set up to address the certainty of closing, are examined. Financial terms, key concepts and important conditional provisions are covered. Required Reading: Note on Private Equity Deal Structures, Tuck School of Business at Dartmouth, 2005, Case # 5-0006 Case: “Texas Pacific Group – J, Crew,” 2007, HBS Case # 9-808-017. This case describes Texas Pacific Group's purchase and operation of J. Crew, the catalog and specialty clothing retailer. Highlights the issues involved in financing such a transaction, and then focuses on the operational challenges of turning around the business, and of TPG's intensive involvement in the running of the business. Details the improvements in the business and then the retrenchment, leaving the business facing a significant debt
payment coming due. TPG must decide whether to sell the business and get out "whole," or whether it can develop and execute a more successful strategy going forward. Session 6: HARVESTING INVESTMENTS THROUGH IPO This session describes the Initial Public Offering process and the role private equity firms in harvesting investments through IPOs. An exit mechanism of harvesting a growing and profitable business is going public and selling the stock in the open market through an IPO. Exiting shareholders and incoming investors have the marketplace, as the ultimate valuing mechanism, to determine the share price. This session examines how a successful IPO can provide high valuation and can generate an infusion of cash for the firm's future growth. Required Reading: Cendrowski, Harry, Martin, James P., Petro, Louis W., and Wadecki, Adam A, Private Equity, History, Governance, and Operations, John Wiley & Sons (New York, NY, 2008), Ch 4 Note on the Initial Public Offering Process, 1999, HBS Publication # 9-200-018 Case: “Warburg Pincus and emgs: The IPO Decision (A),” 2007, HBS Case #9-807-092. Two partners of Warburg Pincus, a global private equity firm, are trying to decide whether to take a portfolio company public, and on what exchange. The company, Norway-based ElectroMagnetic GeoServices (emgs), has developed a market-leading technology that determines whether an undersea rock formation contains oil--prior to the oil company drilling a hole. With its high-growth characteristics, emgs is very different from the typical oilfield services company, and would be more suitable for floating on the NYSE or LSE, where liquidity and valuations would also be greater than on the Oslo Bors, the other possibility. Yet floating in the U.S. would involve greater compliance expense and might also require the management team to move to New York or Houston, something the team is reluctant to do. The partners need to decide what to do before the IPO window for energy-related companies closes. Session 7: HARVESTING INVESTMENTS THROUGH M&A This session describes the role private equity firms in harvesting investments through mergers and acquisitions. This session explores the importance of private equity firms in merger and acquisitions activity and covers the types of takeovers, the take over process, analysis of potential buyers and negotiating an agreement. Examined are the roles of the general partners, the limited partners, the management team and the acquiring enterprise in negotiating and closing the transaction. Required Reading: Cendrowski, Harry, Martin, James P., Petro, Louis W., and Wadecki, Adam A, Private Equity, History, Governance, and Operations, John Wiley & Sons (New York, NY, 2008), Ch 5 Role of Private Equity Firms in Merger and Acquisition Transactions, 2006, HBS Case# 9-206-101 Case: “Carlton Polish Co.,” 1983, HBS Case # 9-283-008. This case is devoted to determining the fair market value of Carlton Polish Co. and deciding if Mr. Carlton should buy out his partner's half for $25 million. Carlton's alternative is to sell his half for $25 million. Students must also evaluate a financing plan.
Session 8: MID-TERM ASSIGNMENT AND PRESENTATION The mid-term will be a study group activity, and the deliverable shall be a group presentation. Each study group will be assigned a private equity case, and each group shall give a presentation to demonstrate their
understanding of the techniques and key issues of in private equity investments. The duration of presentations in classroom shall not exceed 20 minutes per group. Session 9: DUE DILIGENCE This session covers the intellectual framework necessary to perform due diligence in private equity settings. All potential issues must be uncovered because they affect the price investors will pay for the company. This session discusses the challenges to due diligence in the private equity environment and provides the framework and guidance to conduct private equity investment due diligence. Required Reading: Cendrowski, Harry, Martin, James P., Petro, Louis W., and Wadecki, Adam A, Private Equity, History, Governance, and Operations, John Wiley & Sons (New York, NY, 2008), Ch 9 A Guide to Private Equity Fund Investment Due Diligence, 2005, Private Equity International Cases: AIT Group Plc., 2003, HBS Case # 9-803-104. A U.S. venture capital firm has just learned that the deal structure for purchasing an illiquid U.K. software firm is unacceptable to institutional investors. The group must decide if it still wants to go through with the deal. This decision hinges on whether the investors are confident that their due diligence has uncovered all the issues that affect the price investors will pay for the company. Summit Partners--The FleetCor Investment (A), 2006, HBS Case # 9-807-033. Summit Partners has negotiated a letter of intent with FleetCor, a firm that operates a fuel payment network for vehicle fleets. This case presents the basic investment thesis and analysis that the deal team has done to get to this stage of the private equity buy out. Brazos Partners and Cheddar's Inc., 2006 HBS Case # 9-806-069. Brazos Partners must decide whether to invest more money in Cheddar's restaurant chain, which the firm invested in 10 months earlier. The incremental investment would fund a real estate subsidiary that would own the property on which Cheddar's built its stores. As the Partners consider the issue, they must decide how to price the new stock, how to structure the deal to limit his firm's dilution, and how to manage the personality issues involved. Session 10: PUBLIC INFRASTRUCTURE INVESTMENTS This session introduces Public-Private Partnerships (PPPs) and describes situations in which they are better than conventional, regulated privatization. This section examines the PPP framework for infrastructure development and addresses obstacles and benefits in the worldwide applications of PPP. Lastly, institutional requirements for a successful PPP are examined, including study of the proper structuring and governance of a PPP contract. Required Reading: Towards a Comprehensive Understanding of Public Private Partnerships for Infrastructure Development, 2009, HBS Publication CMR-418 A Note on Private Equity in Developing Countries, 2007, HBS Publication # 9-208-037 Case: IDFC India: Infrastructure Investment Intermediaries, 2010, HBS Case 9-210-050. Indian financial intermediary matching international capital to local infrastructure decides how to balance range of services, risk adjusted return, margin pressure, and nation building. IDFC was chartered with partial ownership from the Indian government to help evaluate policy and be a model for how private finance could be attracted to public infrastructure. As the nation and company grow, the firm also grows and embarks on a strategy of rapid expansion, offering a wide new range of financial products, and participating in many aspects of the supply chain.
Session 11: SOVERIGN WEALTH FUNDS The session describes the various types and origins of sovereign wealth funds (SWFs), their orientation, and their recent intensive investment activity in the global financial-services sector. The transparency of SWFs and their role in the global financial system as liquidity-providing long-term players is also discussed. This session also covers the factors to be considered when making a decision to issue capital and place it with sovereign wealth funds. Required Reading: The Case of Sovereign Wealth Funds: A New (Old) Force in the Capital Markets, 2008, HBS Publication # UV1059 Case: Capital Alliance Private Equity: Creating a Private Equity Leader in Nigeria, 1999, HBS Case # 800104. This case describes the creation of the first private equity fund in Nigeria and the fund's potential first investment in GS Telecom, a Nigerian telecommunication service company. The fund's managers are keenly aware that a bad first investment could create a vicious circle for the fund. Thus, whether to invest and under what terms is of crucial importance. Session 12: PRIVTE EQUITY, CORPORATE GOVERNANCE AND ETHICS This session is devoted to cultural, legal, ethical and moral issues surrounding the use of private equity. Matters of confidentiality, transparency, corporate governance, self-regulation and legislative acts are addressed. Also examined are the legal and ethical responsibilities of corporate directors and officers, executives, managers and employees at all levels. Required Reading: Demaria, Cyril, Introduction to Private Equity, John Wiley & Sons (New York, NY, 2010), Ch 7 Corporate social responsibility, corporate governance, and financial performance: Lessons from finance, 2008, HBS Publication # BH304. Case: Accounting Fraud at WorldCom, 2004, HBS Publication # 104071. The case provides sufficient detail to allow for a full discussion of the pressures that lead executives and managers to "cook the books," the boundary between earnings smoothing or management and fraudulent reporting, the role for internal control systems and internal audit to prevent or rapidly detect accounting fraud, the expectations about governance processes performed by external auditors and the board of directors, and the pressure and consequences when middle managers follow orders that they know are wrong. Session 13: LEGAL CONSIDERATIONS IN EXIT STRATEGIES This session is devoted to the legal matters that must be considered when selecting an exit strategy – IPO versus sale. Also covered are challenges that may be encountered: weak capital markets may affect the ability to successfully launch an IPO; distributing thinly traded stock presents a challenge to a sale transaction. Required Reading: Cendrowski, Harry, Martin, James P., Petro, Louis W., and Wadecki, Adam A, Private Equity, History, Governance, and Operations, John Wiley & Sons (New York, NY, 2008), Ch 16. Between a Rock and a Hard Place: Valuation and Distribution in Private Equity, 2003, HBS Case # 803161. Case: Exxel Group: March 2001, HBS Case # 202053. The Exxel Group, a leading Latin American buyout fund, faces a challenge when deciding whether and how to exit its largest investment. The capital markets
are very weak, precluding an initial public offering. Undertaking a trade sale of the firm, however, proves to be challenging. Session 14: SOURCING OF PRIVATE EQUITY DEALS AND MANAGEMENT OF PORTFOLIO COMPANY EXPECTATIONS The buyout fund’s goal of deal sourcing is to find high quality deals. This session covers the types of deals, the models for finding deals and that the factors that lead to deals with high returns. Sourcing, and evaluation, firm reputation, specialization and competitive advantage are addressed. Required Reading: Evaluating a General Partner’s Deal Flow – Considerations for gauging this important determinant of success. Megrue, John F., Jr. Case: Carlyle Japan (A), 2008, HBS Case # 9-508-092. Carlyle Japan wants to formulate a strategy to improve his firm's ability to source high quality deals at competitive valuations. Since the profitability of a buyout depends on finding high quality deals, the firm has focused on leveraging its contacts in the Japanese banking business. These contacts have brought to Carlyle a number of good quality companies, but the volume of buyouts done by Carlyle in Japan has low. JP Morgan Partners--Cabela's Inc., 2007, HBS Case # 9-208-026. JP Morgan Partners (JPMP), the private equity arm of JP Morgan Chase, owned 15% of Cabela's, Inc., a hunting and fishing equipment retailer in the U.S. In 2003, the founders Dick and Jim Cabela wanted to liquidate some of their holdings. However, Cabela's was not ready for an IPO, and the brothers were not interested in selling Cabela's to a strategic acquirer.
Session 15: GROUP CASE WRITE-UP AND FINAL PRESENTATION Study group’s research would require analysis of a particular private equity investment. Time permitted for each group presentation is restricted to 30 minutes. The cases will be distributed two weeks in advance.
