PRIVATE EQUITY AND HEDGE FUNDS (ALTERNATIVE INVESTMENTS) Defining the alternative-investment industry is a challenging task, mostly because of the overlapping structure of the main types of alternative investments, but INTRODUCTION also for definitional differences across countries. First it is worth separating the industry into two groups: i) private equity and ii) hedge funds. PRIVATE EQUITY A rather broad definition of private equity might sounds like this: “a professionally managed pool of money raised for the sole purpose of making actively-managed direct equity investments in private companies and with a well defined exit strategy (sale or IPO)”. Within the private equity industry it is possible to further classify three main areas: i) venture capital, ii) buyout, and ii) distress. The key feature defining VC is excepted rapid “internal growth” of the backed companies: that is proceeds are used to build new business, not to acquire existing business. As a simple classification the VC industry can be broken down into: early-stage, ii) expansion-stage, and iii) late-stage. Seed – A small amount of capital provided to prove a concept and to qualify for start-up financing. Early Start-up – Completing development, market studies, assembling key management, developing a business plan. Ready to conduct business. VENTURE Expansion Fixed and working capital financing, marketing. It may or may not be showing a profit. CAPITAL (VC) Fairly stable growth is reached. Again, it may or may not be profitable, but the likelihood of profit is higher than in previous stages. Late !!! – Truly early stage investment are generally financed by angels (they uses their own money) rather than VC (less than 2% of VC investments).
BUYOUT
!!! – In late-stage financing is included the “bridge” financing: this stage is needed at times when the firm plans to go public within six months to a year. Buyout investing is the largest category of private equity in term of funds under management. Buyout investors pursue a variety of strategies, but the key feature is that they almost always take the majority of their companies. In contrast VCs usually take minority stakes. In large buyouts of public companies (such as the purchase of RJR Nabisco by KKR in 1989) investors usually put up an equity stake and borrow the rest form banks and public markets, hence the term leveraged buyouts (LBO). Most buyouts firms are engaged in purchasing “middle-market” firms. !!! - Usually buyout firms have stable cash flows and limited potential for internal growth, although this is not always true.
!!! - A related strategy is “buy-and-build”, where a buyout investor acquires a series of firms in a fragmented industry. Distress investors focus on troubled companies. Because many distress investments are buyouts, this category intersects with the previous one. HEDGE FUNDS Hedge funds (HF) are flexible investing vehicles that share many characteristics of private equity funds. The main difference is that hedge funds tend to invest in public securities. Moreover, in contrast to other pooled investment vehicles, hedge funds make extensive use of short-selling, leverage, and derivatives. Hedge funds are usually classified according to their investment style. It is possible to group strategies into four major sets. Directional Market neutral Event-driven Multiple Long/Short Equity Fixed income arbitrage Risk (Merger) arbitrage Dedicated short bias Convertible arbitrage Distress Global macro Equity market neutral Regulation D Funds of funds Emerging markets Multiple strategies Managed futures !!! - These are also known as “arbitrage” or “relative !!! - These are also known as “special situations”. Profit value” funds. They search for arbitrage to exploit opportunities arise from special occasions in firm’s life, such as !!! - They try to anticipate market various price discrepancies. M&As, reorganizations, or bankruptcies. movements. The greatest overlap with private equity is on distress investing: while private equity funds tend to gain control of the distressed company, restructure it e resell, hedge funds (eventdriven) usually trade securities of distressed companies with the intention of making a profit by quickly reselling these securities. DISTRESS
!!! – The distinction between hedge funds and private equity funds has grown more blurred. For now, VC investing remains relatively free of hedge-fund involvement. !!! – Due to the inaccurate nature of the expression “hedge fund”, the European Parliament decided to use the term “Sophisticated Alternative Investment Vehicles”. Why alternative investments in an investment banking course? Three reasons for including alternative investments in an investment banking course. 1) Private equity funds and hedge funds are increasingly important clients of investment banks (corporate finance: about 30% (EU) and 20% (US) of M&A fees are generated by private equity funds, about 50% of IPO are venture-backed (60% among IT firms) and brokerage for hedge funds). 2) Investment banks are increasingly important players of alternative investments: virtually all major investment banks have a private equity fund and/or a hedge fund, Goldman Sachs has more capital invested in private equity than any other private equity player, and its hedge fund is one of the largest. 3) Some hedge funds strategies are closely linked to investment banking activities (e.g. merger arbitrage) !!!- For all of these reasons there is an increasing mobility of human resources from investment banking to alternative investment industry. Moreover, being asset management, alternative investments activities are investment banking. Giuliano Iannotta – IEMIF – Università Bocconi
Group
Strategy
Long/Short Equity Hedge
Dedicated Short Bias Directional Global Macro
Emerging Markets
Risk (Merger) Arbitrage
Event Driven
Distressed/ High Yield Securities
Regulation D, or Reg. D
Fixed Income Arbitrage
Market Neutral
Convertible Arbitrage
Equity Market Neutral
Multi-Strategy Multiple Fund of Funds Source: CSFB/Tremont Index
Description This directional strategy involves equity-oriented investing on both the long and short sides of the market. The objective is not to be market neutral. Managers have the ability to shift from value to growth, from small to medium to large capitalization stocks, and from a net long position to a net short position. Managers may use futures and options to hedge. The focus may be regional, such as long/short US or European equity, or sector-specific, such as long and short technology or healthcare stocks. Long/short equity funds tend to build and hold portfolios that are substantially more concentrated than those of traditional stock funds. Dedicated short-sellers were once a robust category of hedge funds before the long bull market of the late 1990s rendered the strategy difficult to implement. A new category, “short biased”, has since emerged. The strategy is to maintain net short as opposed to pure short exposure. Short-biased managers take short positions in mostly equities and derivatives. The short bias of a manager’s portfolio must be constantly greater than zero to be classified in this category. Global macro managers carry long and short positions in any of the world’s major capital or derivative markets. These positions reflect their views on overall market direction as influenced by major economic trends and/or events. The portfolios of these funds can include stocks, bonds, currencies and commodities in the form of cash or derivatives instruments. Most funds invest globally in both developed and emerging markets. This strategy involves equity or fixed income investing in emerging markets around the world. Because many emerging markets do not allow short-selling, nor offer viable futures or other derivative products with which to hedge, emerging market investing often employs a long-only strategy. This strategy invests in listed financial and commodity futures markets and currency markets around the world. The managers are usually referred to as Commodity Trading Advisors, or CTAs. Trading disciplines are generally systematic or discretionary. Systematic traders tend to use price and market-specific information (often technical) to make trading decisions, while discretionary managers use a judgemental approach. Specialists invest simultaneously long and short in the companies involved in a merger or acquisition. Risk arbitrageurs are typically long in the stock of the company being acquired and short in the stock of the acquirer. By shorting the stock of the acquirer, the manager hedges out market risk, and isolates his/her exposure to the outcome of the announced deal. The principal risk is deal risk, should the deal fail to close. Risk arbitrageurs also often invest in equity restructurings such as spin-offs or “stub trades” that involve the securities of a parent and its subsidiary companies. Fund managers invest in the debt, equity or trade claims of companies in financial distress or already in default. The securities of companies in distressed or defaulted situations typically trade at substantial discounts to par value due to difficulties in analyzing a proper value for such securities, lack of street coverage, or simply an inability on behalf of traditional investors to value accurately such claims or direct their legal interests during restructuring proceedings. Various strategies have been developed by which investors may take hedged or outright short positions in such claims, although this asset class is in general a long-only strategy. Managers may also take arbitrage positions within a company’s capital structure, typically by purchasing a senior debt tier and shortselling common stock, in the hope of realizing returns from shifts in the spread between the two tiers. This sub-set refers to investments in micro and small capitalization public companies that are raising money in private capital markets. Investments usually take the form of a convertible security with an exercise price that floats or is subject to a look-back provision that insulates the investor from a decline in the price of the underlying stock. The fixed income arbitrageur aims to profit from price anomalies between related interest rate securities. Most managers trade globally with a goal of generating steady returns with low volatility. This category includes interest rate swap arbitrage, US and non-US government bond arbitrage, forward yield curve arbitrage, and mortgage-backed securities arbitrage. The mortgage-backed market is primarily US-based, over-the-counter (OTC) and is particularly complex. This strategy is identified by hedged investing in the convertible securities of a company. A typical investment is long in the convertible bond and short in the common stock of the same company. Positions are designed to generate profits from the fixed income security as well as the short sale of stock, while protecting principal from market moves. This investment strategy is designed to exploit equity market inefficiencies and usually involves having simultaneously long and short matched equity portfolios of the same size within a country. Market neutral portfolios are designed to be either beta or currency neutral, or both. Well-designed portfolios typically control for industry, sector, market capitalization, and other exposures. Leverage is often applied to enhance returns. Multi-Strategy funds are characterized by their ability to allocate capital dynamically among strategies that fall within several traditional hedge fund disciplines. The use of many strategies, and the ability to reallocate capital between them in response to market opportunities, means that such funds are not easily assigned to any traditional category. The Multi-Strategy category also includes funds that employ unique strategies which do not fall under any of the other descriptions. A fund will employ the services of two or more trading advisors or hedge funds who/ which will be allocated cash to trade on behalf of the fund. (see www.hedgeindex.com).
Giuliano Iannotta – IEMIF – Università Bocconi
PRIVATE EQUITY: INTRODUCTION
US versus EU
US EU Limited partnership (sponsored by PE firms). PE firms are small organizations (averaging 10 professionals) who Funds managed by investment companies. Investment companies (e.g. serve as the general partners (GP) for PE funds. A VC fund is a the SGR of the Italian laws) manage close-end funds, with a finite limited partnership with a finite lifetime (usually ten years). The lifetime (the same as in the US). Organization limited partners (LP) of PE funds are the investors. !!! - A mix of cultural and legal reasons justifies this difference. However, it is important to notice that the agreement (especially in term of compensation) that ties the GPs/Investment companies to the LPs/Investors is pretty much the same. For ease of exposition I will refer to the US model henceforth. Source of funds Primarily pension funds (from the 1978 “prudent man” rule) Primarily banks Stage Important role of VC More relevance of buyout Exit IPO Trade sale When a fund is raised the LPs promise to provide a given capital, either on a set schedule or at the discretion of the GP: the capital infusions are known as capital call, drawdown, or takedown. The total amount of promised capital is called committed capital: once the committed capital is raised, the fund is closed. The typical fund will draw down capital over its first five years (the investment period or commitment period). !!! – A successful PE firm will raise a new fund every few years and number its successive fund. If the first fund is closed in 2003, this would be the vintage year. All successive funds (sponsored by the same GP) will be compared to this one. The compensation of the GP is usually divided into: i) management fee and ii) carried interest (or just carry). MANAGEMENT FEE The typical arrangement is for LPs to pay a set percentage of committed capital every year, most commonly 2.5%. Sometimes the fee is constant over time, sometimes it drops after the first five years. The lifetime fees are the sum of the annual management fees for the life of the fund. The investment capital is the committed capital less the lifetime fees. Example – Consider a fund with committed capital equal to €100 ml. and 2.5% management fee for all the 10 year life of the fund. The lifetime fees are €25 ml. and the investment capital is €75 ml. The fund needs to earn at least a 33% of lifetime return on its investment just offset the management fee.
THE AGREEMENT
!!! – Sometimes the fee schedule is much more complex. For example, “increasing then decreasing” schedules are not unusual, with the logic that fund expenses often reach their maximum in the middle years. !!! – An alternative approach - The industry-standard practice is to compute the management fee on committed capital, but there is another method. First, let’s define the difference between realized and unrealized investments: the former are those investments that have been exited (or those in companies that have been shut down), while the latter are those investments that have not yet been exited in companies that still exist. The cost basis of an investment is the value of the original investment. The invested capital is the cost basis for the investment capital that as has been deployed. The net invested capital is the invested capital minus the cost basis of realized investments. It is common to see the management fee base change from committed to net investment capital after the fiveyear investment period is over, thus minimizing the incentive to overinvest in early years. !!! – Final comments – First, management fee usually do not cover all the operating expenses. Second, we have assumed that exit proceeds cannot be reinvested into new companies, but most contracts allow reinvestment rights, subject to given requirements (e.g. the original investment has been exited within 1 year). When reinvestment does occur, the sum of investment capital and lifetime fees would be greater than committed capital. CARRIED INTEREST (CARRY) The basic idea is simple: if the committed capital is €100 ml. and total exit proceeds are €200 ml., the total profit is €100 ml. A 20% carried interest would produce €20 ml. The standard carried interest is indeed 20%, but recently higher carried have been seen (e.g. 25% or even 30%). There are many variations of the basic story. 1) Carried interest basis - It is the threshold that must be exceeded before the GPs can claim a profits: the majority of funds use the committed capital, but sometimes the investment capital is used. 2) Timing – Many funds require the return of (at least a portion of) the invested capital (or contributed capital) before any carried interest can be returned. Contributed capital is the portion of committed capital that has already been transferred from the LPs to the GPs. Clearly, this timing is more GP-friendly than requiring the return of the whole basis. 3) Priority return – The GP promises some preset rate of return to the LPs before the GPs can collect any carry. Most priority return also have catch up provision, which provides the GPs with a greater share of the profits once the priority return has been paid and until the preset carry percentage has been reached. Priority return is also known as preferred return or hurdle return. 4) Clawback – The early payment of carried interest can cause complications if the fund starts off strong but weakens later in life. The refund of carried interest is accomplished with a contractual provision known as clawback. This provision is complicated by many factors: e.g. the GPs do not have the money (usually there is a guarantee by individual GPs), or specification of whether clawback will be net or gross of taxes already paid by the GPs. Giuliano Iannotta – IEMIF – Università Bocconi
CARRIED INTEREST: SOME EXAMPLES CARRIED INTEREST BASIS Consider two different carried interest structures for a €100 ml. fund. Both structures have management fee of 2.5% per year (on commitment capital) for all ten years. Under structure I, the fund would receive a 20% carry with a basis of all committed capital. Under structure II, the GPs would receive a 18% carry with a basis of all investment capital. Suppose the total exit proceeds from all investments are €200 ml. over the entire life of the fund. Structure I – Carried interest would be 20%·(200 – 100) = €20 ml. Structure II – Lifetime fees are 2.5%·€100 ml. 10 years = €25 ml. The investment capital is therefore €75 ml. The carry is hence 18%·(200 – 75) = €22.5 ml. For what amount of exit proceeds would these two structures yield the same amount of carried interest? €325 ml. (carry equal to €45 ml.) TIMING and PRIORITY RETURN Consider a €100 ml. fund with a 20% carry on commitment capital, a priority return of 8%, and a 100% catch-up. Imagine that all committed capital is drawn down on the first day and that there are total exit proceeds of €200 ml., with €108 ml. of these proceeds coming one year after the first investment, €2 ml. coming one year later, and €90 ml. coming the year after that. Under this rule all €108 ml. would go the LPs, satisfying the 8% priority return. On year later the catch up provision implies that the whole €2 ml. would go the GPs, thus receiving the 20% of the profits. The final distribution would be split €72 ml. for the LPs and €18 ml. for the GPs. !!! – The presence of a priority return and a catch-up provision affect the timing of the carry, but not the amount. In contrast, the absence of catch up provision would have meant that the GP would have received only 20%·(200 – 108) = €18.4 ml. CLAWBACK Suppose that a €100 ml. fund has a 20% carry with a basis of all committed capital, but allows carried interest to be paid as long as contributed capital has been returned. Imagine that at the third year, contributed capital is €50 ml. and the first exit produces €60 ml. Given the carry rules, the fund would return the first €50 ml. to its LPs, and the remaining €10 ml. would be split as €8 ml. for the LPs and €2 ml. for the GPs. Now, suppose that at the end of the fund (seven year later) there is no more exit. Contributed capital is now €100 ml., but the LPs have only received back the €58 ml. form the first and only exit. With a clawback provision they will get back the carry already paid. Example – Consider the following (fictional) fund. Fund size - €500 ml. Management fees – All management fees are computed based on committed capital. These fees are 2% in years 1 and 2, 2.25% in years 3 and 4, 2% in year 5, 1.75% in year 6, 1.50% in year 7, 1.25% in year 8, 1% in year 9, and 0.75% in year 10. These fees will be paid quarterly, with equal installments within each year. Distributions – Distributions in respect on any partnership investment will be made in the following order of priority: i) ii)
100% to the limited partners until they have received an amount equal to their contributed capital; 75% to the limited partners and 25% to the general partners.
General Partner Clawback Obligation – Upon the liquidation of the fund, the general partner will be required to restore funds to the partnership to the extent that it has received cumulative distributions in excess of amounts otherwise distributable pursuant to the distribution formula set forth above, applied on an aggregate basis covering all partnership investments, but in no event more than the cumulative distributions received by the general partner solely in respect of its carried interest.. !!! – Cutting though the legal language, these terms mean that the carry is 25%, the carry basis clawback at the end of the fund if too much carry has been paid. Year 1 2 83,25 83,25 Investments 83,25 333,00 Estimated portfolio value Assume that the investment 0,00 249,75 Distributions capital is distributed evenly in Cumulative distributions each of the first five years. The 15,81 Distributions to GPs first year investment triples in 15,81 Cumulative distributions to GPs value and exited and the end of 233,94 Distributions to LPs year 2. Following this year, all 233,94 Cumulative distributions to LPs investments lose half of their 83,25 83,25 Portfolio value after capital returned value each year. Distribution is 10% of portfolio value in years 3 0,02 0,02 Management fee % and 4, and 40% in the 10,00 10,00 Management fee remaining years. 93,25 186,50 Contributed capital 83,25 166,50 Invested capital Clawback
is committed capital, the timing method uses contributed capital, and there is a 3 83,25 124,88 12,49
4 83,25 139,44 13,94
5 83,25 146,00 58,40
6 0,00 43,80 17,52
7 0,00 13,14 5,26
8 0,00 3,94 1,58
9 0,00 1,18 0,47
10 0,00 0,35 0,14
Close 0,00 0,11 0,04
0,00 15,81 12,49 246,43 112,39 0,02 11,25 281,00 249,75
0,00 15,81 13,94 260,37 125,50 0,02 11,25 375,50 333,00
0,00 15,81 58,40 318,77 87,60 0,02 10,00 468,75 416,25
0,00 15,81 17,52 336,29 26,28 0,02 8,75 477,50 416,25
0,00 15,81 5,26 341,55 7,88 0,02 7,50 485,00 416,25
0,00 15,81 1,58 343,12 2,37 0,01 6,25 491,25 416,25
0,00 15,81 0,47 343,60 0,71 0,01 5,00 496,25 416,25
0,00 15,81 0,14 343,74 0,21 0,01 3,75 500,00 416,25
0,00 15,81 0,04 343,78 0,06
Giuliano Iannotta – IEMIF – Università Bocconi
500,00 416,25 15,81
FUND RETURNS
The standard measure in PE performance reporting is IRR. However there are some standard practices of IRR calculation which can lead to confusion. 1)
IRR is usually computed quarterly (or even monthly). Annualizing versions of monthly or quarterly IRR might be misleading because this explicitly assumes reinvestment even when such reinvestment has explicitly not occurred. For example, consider a €1 ml. investment that returns €80.000 every month for one year and then returns €1 ml. at the end of the year. The investment has clearly returned 8% in every month. If we annualize this return we get 151% (the implicit assumption is that every distribution has been reinvested). A true annual IRR of 151% should be leaving the investors with €2.51 ml. and the end of the year.
2)
Standard IRR reporting does not usually make a distinction between realized and unrealized investments (the latter being considered as a positive cash flow in the final period). The IRR is then particularly misleading in first few years of a fund. Even for funds that eventually have high IRRs, a plot of the fund IRR will be negative for the first few years, and then increase rapidly in later years (J-curve or hockey stick).
INTRO 3)
The IRR is an answer to the question “how well did you do with my money while you had it?”. Many investors would like to get an answer to a different question: “Overall, how much money did you make for me?” The IRR is not able to answer this question. Suppose for example an investment of €1 ml. returning €2 ml. after 1 year, and a similar investment that returns €32 ml. after 5 years. Both investments have a 100% IRR, but clearly the second one is preferred. This is why the industry introduced another simple measure: the value multiple (also known as, investment multiple, realization ratio, absolute return, multiple of money, cash multiple, times money). This measure answers the question: “For every euro I gave you, how much did I get back?”. The value multiple is the sum of the realized value multiple and unrealized value multiples. EXAMPLE The €200 ml. ABC fund is seven years into its ten-year life. To compute IRR we first need to aggregate the investments, fees, and distributions into a single cash flow to LPs. The value multiple is the ratio of total distributions to LPs plus the value of unrealized investments to invested capital plus management fees.
!!! – Generally, value multiple is computed on a net basis, with fees and carry already subtracted. In some cases, firms may report value multiples on a gross basis, including at the numerator the carried interest, and not subtracting at the denominator the management fee. This gross value multiple represent a better measure of pure performance. Year 1,0 2,0 3,0 4,0 5,0 6,0 7,0 Total 20,0 30,0 40,0 40,0 30,0 0,0 0,0 Investments 160,0 20,0 56,0 112,8 186,6 188,1 195,7 203,5 Portfolio value 0,0 0,0 0,0 65,0 37,6 39,1 40,7 Total distributions 0,0 0,0 0,0 0,0 0,0 0,0 0,0 Carried interest 0,0 0,0 0,0 65,0 37,6 39,2 40,7 Distribution to LPs 182,5 0,0 0,0 0,0 65,0 102,6 141,8 182,5 Cumulative distributions to LPs 20,0 56,0 112,8 121,6 150,5 156,5 162,8 Portfolio value after capital returned 4,0 4,0 4,0 4,0 4,0 4,0 4,0 Management fee 28,0 Cash Flow to LPs
-24,0 IRR
24%
Value multiple
1,84
Realized value multiple
0,97
Unrealized value multiple
0,87
-34,0
-44,0
21,0
Giuliano Iannotta – IEMIF – Università Bocconi
3,6
35,2
199,5
THE TERM SHEET (PROTECTING FROM EXPROPRIATION): PREFERRED STOCK
INTRO
EXAMPLE
A PE fund typically signals its intention to invest by offering a term sheet to the potential portfolio company. In particular, VCs make lumpy investments organized into sequential rounds. A first-round investment is designated as Series A, a second-round of investment as Series B, and so on. Term sheets can be thought of as a starting point for a good-faith negotiation. Term sheets are broken into sections, with each section providing a summary for a longer legal document that will be executed at closing. The big picture is that a term sheet describes the basic structure of a transaction and provides a set of protections against expropriation. !!! – In some cases the investment is spread across multiple payments, knows as tranches, which may be contingent on the firm reaching some preset milestones (e.g. a working prototype). Tranching is much more frequent in first rounds (Series A). The purpose of a term sheet is illustrated by this example. Mario Web has a tremendous idea for an IT company and goes to a VC, Frank Fund. Web and Fund agree that €1.5 ml will fund the project and they further agree to a 2/3-1/3 split, with Web holding the majority stake. Suppose that Fund agrees to an all common stock structure. Immediately after the closing, the company has an implied value of €4.5 ml (Fund is paying €1.5 ml for 1/3 of the company). The day after, Web receives a €2.1 ml offer for his company (which basically consists in cash and Mario Web’s idea). What is the result? Web and Fund get €1.4 ml. and €0.7 ml respectively. Web’s investment goes form €0 to €1.4 ml, while Fund’s investment goes from €1.5 ml. to €0.7 ml. And this happens in one day. Moreover, someone else can buy Web and his idea for €0.6 ml (since the company has €1.5 ml cash). How could Fund have avoided this disaster? The answer is threefold: i) preferred stock, ii) vesting of founder’s (management and key employees) shares, and iii) covenants (and supermajority provisions).
PREFERRED STOCK (PS) Preferred stock (PS) has a liquidation preference over common stock: that is, in the event of sale or liquidation of the company PS gets paid ahead of the common stock. Generally the face value of preferred stock is the cost basis the VC pays for the stock. In the example, if Fund had invested in the form of PS, then he would have been returned €1.5 ml.. But how would have the remainder €0.6 ml been divided? The answer depends on the type of PS (and on the resulting exit diagram). Convertible Preferred Stock (CPS) Redeemable Preferred Stock (RPS) Participating Convertible Preferred Stock (PCPS) PCPS get the face vale and also receive any additional RPS is preferred stock with no convertibility into equity. CPS can be converted at the shareholder’s option into proceeds that would have been generated if it had also Although a VC would never accept RPS by itself, some common stock. The shareholders is forced to choose converted into common stock. In this respect, we could transactions will combine RPS with common stock or whether he will take his returns through the liquidation say that PCPS is like having RPS plus common stock. It is CPS. Suppose for example Fund agreed with Web to the feature (redemption) or though the underlying common important to remember that this liquidation preference same 2/3-1/3 split, but in the form of RPS. Fund would equity position. Clearly, if the value being offered for the only applies in the case of a “deemed liquidation event” have received €1.5 ml for its RPS and 1/3 of the company (W) exceeds the implied total value at the time of (i.e. when a company is sold, merged, or shut down). If remainder €0.6 ml. He would in effect, be getting his the investment, then the shareholder will convert the PCPS is converted it becomes like common stock. Some money bank and keeping his investment. This doublepreferred stock to common stock. events may trigger mandatory conversion, e.g. a qualified dipping is troubling to entrepreneurs. Moreover, when a CPS (conversion value) = 1/3·W public offering (QPO), which is an IPO that meets certain material portion of the proceeds in an IPO is used to CPS (redemption) = Min(1.5, W) threshold. Suppose that above €12 ml there is a redeem out a VC’s RPS, the market value of the company The conversion condition is 1/3 W > 1.5 W > 4.5 mandatory conversion: the participation threshold is 8 can be adversely affected. times the original investment. CPS
RPS + Common
PCPS Slope = 1/3
Slope = 1/3 5 = 1.5 + 1/3·(12 – 1.5)
Slope = 1/3
Common 4 = 1/3·(12)
1.5
1.5
RPS
PCPS
1.5
Common
Redemption Conversion W 1.5
4.5
W 1.5
4.5
W 1.5
12
In our example, Fund would have left his CPS In our example, Fund would have received the same unconverted and Web would have got the residual €0.6 In our example, Fund would have received €1.5 ml from amount of money as a RPS. ml. CPS allows the entrepreneur to “catch up” to the the RPS redemption and 1/3 of €0.6 ml. !!! – Sometimes PCPS are capped. See the next slide. investor after the investor’s initial investment is secured. !!! – In recent years, it has become common for VCs to ask for liquidation preferences in excess of their original investment. For example, a 2X or 3X liquidation preference requires that the VC be paid back double or triple, respectively, of their original investment before any of the other equity claims are paid off. Giuliano Iannotta – IEMIF – Università Bocconi
THE TERM SHEET: AGAIN ON PREFERRED STOCK
PCPS with CAP Slope = 1/3
PCPS WITH CAP
Sometimes there is cap on liquidation preference of PCPS. Suppose the Fund accepts to be capped at 2 times its initial investment. With a PCPS, Fund would receive €1.5 ml. plus 1/3 of any remaining proceeds, until this total reaches €3 ml. (2·€1.5 ml). The cap point is then: 1/3·(W – 1.5) + 1.5 = 3 W = €6 ml. Given this cap, the VC will choose to convert the PCPS for a lower value than the one which triggers the mandatory conversion (12). Indeed, the VC will (voluntarily) convert when 1/3·W > € 3ml. W > €9 ml. (that is before the mandatory conversion at €12 ml.)
3 Slope = 1/3 PCPS
1.5
W 1.5
6
9
In public companies preferred stock are issued with the promise of cash dividends, but this is not the case in VC. Portfolio companies are usually cash poor and dividends may further limit the ability to raise capital. Moreover, VCs are capital-gains oriented, and dividends create asymmetry of rewards between the preferred shareholders (the VC) and the common shareholders (entrepreneur, management, and/or key employees). DIVIDENDS Nonetheless, in some term sheets you may find something about dividends. In general dividends may be either for cash or stock (payment-in-kind, PIK). In general it is common to find a dividend preference to PS (that is you cannot pay any dividends to common stock unless you first pay dividends to PS). !!! – Dividends rights may be cumulative or non-cumulative, the difference being that cumulative dividends accrue even if not paid. Cumulative dividends in turn can accrue by simple interest or by compound interest. ANTI-DILUTION PROTECTION Many CPS contain anti-dilution provisions that automatically adjust the conversion price down if the company sells stock below the share price that VC has paid (known as down round). The share price of the VC investment is known as original purchase price (OPP). The rationale for these provisions is that the company is presumably selling at a lower price because of underperformance. By having an automatic adjustment, the VC is less likely to oppose a dilutive financing (when it is most needed). The adjustment mechanisms is a negotiated term and can range from complete adjustment (full ratchet) to one based on the size of the round and the size of the price decrease (weighted-average formula). In this latter case we further distinguish between broad-base and narrow-base. Full ratchet – The adjusted conversion price (CP2) is set to the lowest conversion price of any later stock sale. The price is adjusted regardless the round size and price decrease. Weighted-average – CP2 = CP1·(A + B)/(A +C) where CP2 is the adjusted conversion price, CP1 is the conversion price in effect prior to new issue, A is the number of shares of common stock (fully diluted), B is the aggregate consideration received with the new issue divided by CP1 (i.e. the number of new shares that should be issued was the price the OPP), and C is the number of new share issued in the subject transaction. The price is “more” adjusted the larger the round size and the price decrease. In broad-base A includes all shares of outstanding common stock and options on an as-converted basis). In narrow-base A includes just the shares of PS on an as-converted basis): in other words, it considers just the Series A shares, but not the common stock outstanding.
!!! – It is crucial to know the difference between pre-money and post-money valuation (also known as pre-financing and post-financing). The post-money valuation is simply that value of the company once the initial investment has been made (number of shares times the price per share). Subtracting the amount invested in this round form the post-money valuation yields to the pre-money valuation. EXAMPLE Suppose that Frank Fund makes a €6 ml. Series A investment in Newco for 1 ml. shares at €6 per share (the OPP). Newco underperforms and receives a €6 ml. Series B financing from another VC (Desperate Inv.) for €6 ml. share at €1 per share. The founders and the employee stock pool (together the “employees”) have claims on 3 ml. shares of common stock. The employee stock pool contains shares set aside as incentive compensation for employees. Usually computation is done on a fully diluted basis, which assumes that all PS is converted and that all options are exercised. Consider the following cases. Series A has no anti-dilution protection Series A has full-ratchet anti-dilution protection Fund has 1 ml. shares out of a fully diluted share count of 1 ml. + 6 ml. (Series B) + 3 ml The Series A adjusted conversion price would be €1 (the price of Series B), and Fund (Employees) = 10 ml., thus controlling 10%. Series B investors paid €1 per share, so the would control 6 ml. shares of a fully diluted share count of 6 ml. + 6 ml. (Series B) + 3 post-money valuation would be 10 ml.·€1 = €10 ml., and the pre-money valuation would ml. (Employees) = 15 ml., controlling 40%. The post-money valuation would be 15 be €10 ml. - €6 ml. = €4 ml. ml.·€1 = €15 ml., and the pre-money valuation would be €15 ml. - €6 ml. = €9 ml.
Giuliano Iannotta – IEMIF – Università Bocconi
THE TERM SHEET: VESTING AND COVENANTS
VESTING
The idea is simple. It holds that an entrepreneur’s stock does not become his or her own until he or she has been with the company for a period of time, or until some value accretion event occurs (e.g. the sale of the company). Typically vesting is implemented over a time period (step vesting); alternatively, it takes place all at one time (cliff vesting). Sometime an accelerated vesting in case of acquisition is allowed. Vesting performs the function of preventing an employee from leaving and taking with him value disproportionate to the time he was employed at the company. Vesting also performs the function of returning shares to the employee stock pool from employees who “haven’t finished the job”.
!!! – Vesting is sometimes also used for founders’ shares at the time of the first venture capital investment, meaning that a founder who previously owned the whole company must now temporarily hand back his ownership stake and stay for a few years before he gets it back. Covenants are the most basic way VCs protect their investments. Usually VCs are concerned about changes in control. The contracts may state that founders cannot sell any of their common stock without approval (or supermajority voting rule for shareholders or board) of the VCs or offering the securities to the VCs before anyone else (right of first offer) or offering VCs to buy at the price offered by third parties (right of first refusal). The contracts may also allow VCs to sell together with the founder (take-me-along or tag-along right) or to force the founder to sell their stake at the same price (drag-along right), the latter being particularly useful to VCs who need to force a sale of the whole firm. COVENANTS
What is the different between the right of first refusal and the right of first offer? – The right of first refusal is the right to make an offer after offers from others are considered. In contrast, right of first offer, is the right to make an offer before offers from others are considered.
Right of first refusal - Suppose you are looking to sell your shares and VC has a right of first refusal on them. If a third party now comes along and offers €100 for the shares, you have to reveal that price to the VC, and if he chooses to execute his right, he can pay $101 and walk away with the shares. Right of first offer - You are looking to sell your shares and the VC has right of first offer. Step 1: make an offer to your partner to buyout the shares for say €100. Step 2: if they refuse then you can take it out into the open market and see if you can get €100. If you can't, you can't just sell it for a lower number, you need to re-run the process and offer your partner another look.
THE VENTURE CAPITAL METHOD (1)
INTRO
The VC method is a valuation tool commonly applied in the private equity industry. The company value is projected for some terminal year (say five years from the present), based on a “success scenario” (usually relative approach is used). This terminal value is then converted to a present value by applying a very high discount rate, typically between 35% and 80% per year. The resulting figure is the estimated current total value as of today. Given the investment requested to the VC, it is easy to compute the percentage of ownership he will ask. To sum up, three variables are needed: i) the terminal value, ii) the discount rate, iii) the investment size.
!!! - If a company is expected to issue additional shares over its life (thus diluting the ownership of the original investors), the method becomes more complex. THE BASIC VC METHOD (NO DILUTION) Consider a VC evaluating a €1 ml. investment in a company that expects to require no further capital through 5 years. The company is expected to earn €2 ml. in year 5 and Having obtained the percent ownership it is quite easy to infer a value for the company as a whole; if you own 38.0% paying €1 ml., what is the value of the whole company? It P/E for comparables is 10. The VC requires a 50% rate of return. will be €1/38.0% = €2.6 ml. This is the post-money valuation. Alternatively, we may What price should he pay now for the stock? compute the discounted terminal value €20/(1+50%)5 = €2.6 ml. The VC must own enough of the company in year 5 to realize 50% annual return on the investment, thus at that time his shares must be worth (1+50%)5·€1 ml = €7.6 ml. At that point the whole company will be worth 10·€2 ml. = €20 ml. hence, the required percent ownership must be 7.6/20 or 38.0%. When a VC invests in company additional shares are issued (diluting the ownership of previous investors, e.g. the founder). The required percent ownership refers to the portion of total stock after the new shares are issued (that is post-money). The percent ownership (38.0%) should then be equal to new/(new + old), therefore: new = old·(%own)/(1-%own) If there are 1 ml. shares outstanding pre-money, then an additional 612,091 shares must be issued. The share price is the price paid divided by the number of shares purchased, i.e. €1.6
It is sometimes important to consider the value attributable to only that portion of the company not purchased in this round, i.e. the pre-money valuation, which will be equal to the post-money value less the investment (€ 1.6 ml. in our case); this is the implicit valuation attributed to the stock held by the founder (known as sweat equity, because it impound the hard work of the founder).
!!! – These kinds of computation are usually done on a fully diluted basis, i.e. assuming that all convertibles are converted and all options are exercised. !!! – You should be really skeptical about the value attributed with the VC method for at least two reasons: i) the shares purchased by the VC are not comparable to the ones owned by the founders (preferred vs common), ii) vesting prevents the founder from selling his shares.
Giuliano Iannotta – IEMIF – Università Bocconi
THE VENTURE CAPITAL METHOD (2)
THE KEY ELEMENTS
discount rate than an expansion stage). Moreover, the lack of liquidity of private equity investments and the value added by VCs need to be compensated, but a 50% seems to be far too large. In fact, there is another explanation. What if the VC expected a lower terminal value than the forecasted one? In that case, a huge discount rate would simply incorporate a “risk of failure”: the problem here is that the terminal value estimate does not represent the expected terminal value, but the terminal value in case of success. In other words, if you expect the terminal value to be much lower than the forecasted one, by increasing the discount rate you take into account your expectation (without fighting with the entrepreneur about the “real” terminal value).
Discount rate
The key elements of the VC method are the terminal value, the discount rate, and the proposed investment. The usual terminal valuation method used by VCs is the relative approach, i.e. multiples of comparable companies. The investment size is the most certain thing in the VC method. While the total amount of funding to be raised depends on the company’s needs, how much of that amount a given VC will contribute depend on that VC’s needs. For example, for diversification purposes a fund may set a maximum investment level. On the other hand VCs also have a minimum level for any investment, determined either by the size of the investment (e.g. no less than € 1ml. in any given investment) or by the expected return (e.g. the expected exit must exceed €5 ml., regardless of investment size). Expected return The real question is how the discount rate is determined. It is clear that it 15% 20% 25% 30% 35% 40% depends on the stage of financing (a seed stage will require a much higher 20%
1,24
1,00
0,82
0,67
0,55
0,46
30%
1,85
1,49
1,22
1,00
0,83
0,69
40%
2,67
2,16
1,76
1,45
1,20
1,00
50%
3,78
3,05
2,49
2,05
1,69
1,41
60%
5,21
4,21
3,44
2,82
2,34
1,95
70%
7,06
5,71
4,65
3,82
3,17
2,64
Example – Suppose the VC requires a 30% return. Applying a 50% discount rate is equivalent to adjusting the forecasted terminal value by halving it. Indeed, 1.55 = 2.05·1.35
!!! – The “First Chicago” Method – As an alternative it is possible to consider three (or more) possible scenarios, with each scenario weighted according to its perceived probability, thus estimating an expected terminal value (rather than a forecasted one) and employing a lower discount rate. This method was first developed at First Chicago Corp.’s venture capital group. THE VC METHOD ASSUMING FUTURE DILUTION As new stock is issued to later-round investors the early-round investors suffer dilution, i.e. a loss of ownership due to the issuing of additional shares. Early-round investors will have to buy a higher ownership percentage in order to achieve a given terminal ownership. If more stock is issued to early investors, the future investors will have to receive more stock to have a given percent ownership. Thus, to determine the necessary current ownership, the VC must estimate the amount of new stock that will be issued in the future, but this amount depends in part on the amount of stock that will be issue now. How can the VC solve this circularity problem? (1) Estimate the size of the future pie How much will be available to investors and management? The first step is to calculate the terminal value. The company is expected to earn €2 ml. in year 5 and P/E for comparables is 10. At that point the whole company will be worth 10·€2 ml. = €20 ml. (2) Carve up the future pie (3) Convert the future pie into the present Given the ownership levels, one can get the current ownerships, the number of new shares, and the share prices for each round. Using the basic VC formula the final ownership The ratio of the final percent ownership to the current percent ownership is the retention ratio. To illustrate, an investor’s required by each investor can be estimated. First retention ratio will be 75%, if a later investor purchases 25% of the company. The retention ratio can be thought of as the the timing and amount of equity infusions must portion of the final ownership available to the current investor. Thus, because the second-round investor will hold 13.7%, the be projected. first investor will only retain 1 – (13.7%) = 86.3% of his original holding. The second round investor will retain 100% of his A total of two financing rounds are expected: €1 investment, since there will be no subsequent investors through years 3, 4, and 5. So, what percent ownership should each ml. at now, €1 ml. at years 2. A 50% rate is investor purchase at the time of the financing? The current percent ownership is equal the ratio of the final percent ownership appropriate for year 0, while 30% is appropriate to the retention ratio. for year 2. Round 1 Current % = 38.0%/86.3% = 44% Round 1 Final % = (1.505·€1)/€20 = 38% Round 2 Current % = 13.7%/100% = 13.7% 3 Round 2 Final % = (1.40 ·€1)/€20 = 13.7% Using the formula presented earlier we can compute the number of shares each investor must purchase (assuming 1 ml. shares These are the final ownership shares that each outstanding before the first round) and the corresponding price. investor requires. If the terminal value is not high enough the sum of required ownership Round 1 New Shares = 1,000,000·44%/(1-44%) = 785,919 Share price = €1 ml./785,919 = €1.3 might be higher than 100%: in this case there Round 2 New Shares = 1,785,919·13.7%/(1-13.7%) = 283,992 Share price = €1 ml./283,992 = €3.5 would not be enough value to justify the !!! – The final year there will be 1,785,919 + 283,992 = 2,069,911 shares outstanding. If the market value is €20 ml., the price investments needed. per share will be €20 ml./2,069,911 = €9.6
Giuliano Iannotta – IEMIF – Università Bocconi
LEVERAGED BUYOUT (LBO) In a LBO a group of sponsors undertakes the acquisition of a company (or its assets) mainly by borrowing against the Target’s assets or future cash flows. The sponsors are often private equity funds (buyout funds); a management team (incumbent, external, or both) is usually involved. The sponsors create a Newco, which purchases all of the Target’s shares. Target is then merged into Newco (KKR method). It is also possible (not so frequently) that Newco acquires just the Target’s assets (Oppenheimer method). The Newco is financed through 25%-50% equity and 75%-50% debt.
INTRO
!!! – Going-private transaction – When a listed company is acquired and subsequently delisted, the transaction is referred to as a public-to-private or goingprivate transaction. These kinds of transactions (which make extensive use of debt) were originally called LBO (and before “bootstrap” acquisition). In fact, LBOs comprise not only public-to-private transactions but also private firms. !!! – MBO, MBI, BIMBO, and IBO – Management-led deals (backed by a buyout fund) represent the majority of LBOs. When the incumbent management team takes over the firm the LBO is called management-buyout (MBO). When an external management team acquires the firm, the term is management-buyin (MBI). When the sponsor group includes both members of the incumbent management and external managers it is a buyin-management-buyout (BIMBO). Finally, when the sponsor group includes only private equity funds (i.e. “institutions”) the LBO is termed institutional buyouts (IBO). !!! – Reverse LBO – A possible exit strategy for buyout funds is an IPO. Such a “secondary” IPO is usually called reverse LBO. !!! – The Italian case – According to the Italian law (art 2501 bis) only the merger LBO is possible (i.e. the KKR method).
FINANCING STRUCTURE
The total amount to be financed is the EV of the Target and the structure of the debt is not related to the outstanding debt of the Target. LBO financing is generally expressed in terms of debt to EBITDA. However, the typical financing structure is about 5 times EBITDA of debt and about 1.5 times EBITDA of equity for a purchase price of 6.5 times EBITDA. Moreover the debt is usually structured in senior debt (supplied by banks) for about 4 times EBITDA and high-yield bonds/subordinated debt for about 1 times EBITDA (up to 3 times during the ‘80s).
Senior A Senior B EV
=
4x
Senior C
5x 6.5x
Mezzanine
!!! - The feasible debt structure changes over time depending on the market.
Equity
When high-yield debt is not available (either because of the small transaction size or due to the scarce liquidity of the market) the gap is filled by so-called mezzanine financing, provided by specialized investors, the mezzanine funds. These funds demand higher compensation, which involves warrants or other equity-linked instruments (the equity “kicker”) in addition to interest (usually below market) on subordinated debt (repaid only after all senior debt is reimbursed). !!! - LBO debt contract typically provide that any excess cash generated by the business shall be used to repay (senior) debt (“cash sweep”). There are two possible candidates for a LBO: the “stable cash flow” firm and the “high growth” firm. Motives Stable cash flow High growth Stable cash generation reimburses debt. The EV at exit is unchanged: the reduced debt increases the equity value. It is generally a long term LBO with higher leverage (easier to convince the banks). CANDIDATES AND MOTIVES
The gains result from the company’s growth, i.e. the EV increases over time. It is generally a short term LBO with lower leverage (it is more difficult to convince banks).
Debt
Debt
Debt
EV
EV
Debt
EV
Equity
t=0
VALUATION
Equity
EV
Equity
t=1
Equity
t=0
t=1
There are several sources of wealth gains that may motivate a LBO. These are the most relevant: Tax benefit – The increased leverage increases the tax shield. The question is: “Couldn’t the Target obtain the tax benefit without a LBO?” Agency cost – Wealth gains derive from reunification of ownership and control (the “owner-manager”) and increased control quality (due to the buyout fund and to the discipline function of debt). Undervaluation – The wealth gains result from developing an alternative higher-valued use for the firm’s assets.
The price to bid for an LBO depends on two factors: i) the debt capacity of the firm and ii) the return required by the sponsor (i.e, the buyout fund). Debt capacity determines how much is left to sponsors at exit time. The present value of exit equity plus debt capacity is the affordable price for the LBO. Giuliano Iannotta – IEMIF – Università Bocconi
LBO VALUATION (1): DEBT CAPACITY Debt capacity is an estimate of how much the company can borrow against its expected cash flow and still permitting full debt service to senior debt and interest payments to subordinated debt. In practice debt capacity is measured as a multiple of EBITDA. Debt capacity is a function of revenue, costs, and capital expenditure projections: in other words, estimating debt capacity is an exercise in pro-forma forecasting. Debt capacity is then a function of the growth rate of sales and of the sources and uses of cash, also expressed as fractions of revenues. Given the inputs, it is easy to compute cash flow and debt amortization, and to determine how long it will take to pay back all the senior debt: if it takes longer than lenders require, the debt capacity of the firm is lower than initially assumed. With an Excel spreadsheet the problem simply consists in solving for the amount of debt that would result in senior debt balance at the given year.
A simpler (albeit “opaque”) analytical solution exists (assuming cash sweep = 100%):
g
Growth of sales
5,0%
m
EBITDA margin
10,0%
dep
Depreciation/sales
1,5%
onc
Other non-cash/sales (CAPEX+∆ ∆WC)/sales
0,2%
cash Rcash
Cash balance/sales
0,2%
t
Tax rate
inv
[
]
x2 ⋅ m −1 ⋅ x1n − (1 + g ) n /( x1 − 1 − g ) Debt capacity = n x1 ⋅ f + (1 − t ) ⋅ Rsub ⋅ (1 − f ) ⋅ (1 − x1n ) /(1 − x1 )
2,0%
Interest on cash balance
4,5% 40,0%
Debt financing:
with
x1 = 1 + (1 − t ) ⋅ Rsen
x2 = (1 − t ) ⋅ m + t ⋅ dep + onc − inv + (1 − t ) ⋅ Rcash ⋅ cash /(1 + g ) − cash ⋅ g /(1 + g )
Rsen
(f) Senior @
35%
8,5%
Rsub
(1-f) Subordinated @
65%
10,0%
"cash sweep"
100%
n
Amortization of senior by year
sweep
Net cash to senior amortization
5
First year sales
1.000
First year EBITDA
100
Debt Capacity
4,39
x1
1,05
x2
0,48
439,27
4,39
1
2
3
4
5
6
7
8
9
10
1.000,00
1.050,00
1.102,50
1.157,63
1.215,51
1.276,28
1.340,10
1.407,10
1.477,46
1.551,33
100,00
105,00
110,25
115,76
121,55
127,63
134,01
140,71
147,75
155,13
15,00
15,75
16,54
17,36
18,23
19,14
20,10
21,11
22,16
23,27
0,09
0,09
0,09
0,10
0,10
0,11
2,10
4,28
6,66
9,26
Senior interest expense
13,07
11,11
8,86
6,27
3,33
0,00
0,00
0,00
0,00
0,00
Subordinated interest expense
28,55
28,55
28,55
28,55
28,55
28,55
28,55
28,55
28,55
28,55
Income before tax
43,46
49,67
56,40
63,67
71,54
80,04
87,45
95,33
103,69
112,57
Provision for tax
17,39
19,87
22,56
25,47
28,62
32,02
34,98
38,13
41,48
45,03
Net income after tax
26,08
29,80
33,84
38,20
42,92
48,02
52,47
57,20
62,22
67,54
Depreciation and oth. non-cash (CAPEX+∆ ∆WC)/sales
17,00
17,85
18,74
19,68
20,66
21,70
22,78
23,92
25,12
26,37
20,10
21,10
22,16
23,26
24,43
25,65
-17,14
-64,12
-115,55
-171,71
Cash flow before debt amort.
22,98
26,55
30,43
34,62
39,16
44,07
92,40
145,24
202,88
265,63
22,98
26,55
30,43
34,62
39,16
0,00
0,00
0,00
0,00
0,00
0,00
0,00
0,00
0,00
0,00
0,00
0,00
0,00
0,00
0,00
1,90
2,00
2,10
2,21
2,32
2,43
46,63
95,08
148,06
205,84
268,73
Senior debt
153,75
130,76
104,21
73,78
39,16
0,00
0,00
0,00
0,00
0,00
0,00
Subordinated debt
285,53
285,53
285,53
285,53
285,53
285,53
285,53
285,53
285,53
285,53
285,53
Total debt
439,27
416,29
389,74
359,31
324,69
285,53
285,53
285,53
285,53
285,53
285,53
2,41
2,65
2,95
3,33
3,83
4,49
5,07
5,80
6,75
8,04
Debt Capacity
Year 0 Sales EBITDA Depreciation Interest income
Debt amortization: Senior Subordinated Cash balance:
EBITDA/Net Interest Expense
Giuliano Iannotta – IEMIF – Università Bocconi
LBO VALUATION (2): AFFORDABLE PRICE
INTRO
When a cash sweep is in effect, the shareholders do not get any cash. The buyout fund obtains its return through a “cashing out” event (either an IPO or a trade sale). The effects of cashing out are represented in a “terminal value analysis”. Usually some multiples (such as EV/EBITDA or EV/EBIT) are used to estimate the terminal value at the exit year (normally 3/5 years). Using the debt capacity and the terminal EV one can estimate the equity value at the exit year. Given the required return (i.e. discount rate) of the buyout fund it is easy to compute the present value of exit equity. The present value of exit equity plus debt capacity is the affordable price for the LBO. Consider a Target with debt capacity equal to 4 times EBITDA and current EBITDA equal to €100 ml.. In other words, the LBO can borrow €400 ml. Suppose senior debt represents 25% (€100 ml) of total debt and can be amortized at the end of year 5. At that time only the subordinated debt will be left (€300 ml). 1. 2. 3.
EXAMPLE
Estimate the exit equity value - Assume that the sponsor expects to exit the investment in 5 years at 5 times EBITDA. Since the expected EBITDA for the 5th year is €120.00 ml. (growth rate 3.7% per annum), the exit EV would be €600 ml. This implies an exit equity value equal to €300 ml. Estimate the present value of exit equity value – Assume that the sponsor requires 30% return on its investment. Equity cannot exceed €80.8 ml. Compute the affordable price – The affordable price is then the sum of debt capacity, present value of exit equity (less fees and expenses, here assumed to be null): €480.8 ml. (= 400 + 80.8), or 4.8 times EBITDA.
!!! – The calculation assumes an exit multiple close to the purchase multiple. It’s a prudent assumption which puts the burden of value creation in improving operations rather than betting on an increasing multiple. With some simple algebra one can find the exit multiple that equates the affordable entry multiple. Let q be the debt capacity multiple with respect to first-year EBITDA. Assuming that cash is negligible, the value of equity when senior debt has been fully repaid is equal to:
Exit Equity = M X ⋅ EBITDA ⋅ (1 + g ) n − Exit Debt , where M X
THE LBO ALGEBRA
Let
ME
Let
ME = MX = M
be the entry multiple. For a required IRR it will be:
and solve for it:
M=
[(1 + IRR)
is the exit multiple and
Exit Debt = (1 − f ) ⋅ q ⋅ EBITDA
Exit Equity + q ⋅ EBITDA EV M ⋅ (1 + g ) n − (1 − f ) ⋅ q (1 + IRR ) n ME = = = X +q EBITDA EBITDA (1 + IRR) n
]
n
− (1 − f ) ⋅ q (1 + IRR) − (1 + g ) n n
EXAMPLE Given the data of the previous slide let’s determine the exit multiple that equates the affordable entry multiple:
[(1 + 30%) M=
5
]
− (1 − 25%) ⋅ 4 = 4.716 5 (1 + 30%) − (1 + 3.7%) 5
g
3,7%
f
25%
n
5
q
4
IRR
30%
M
4,716
Given an expected EBITDA at year-end 5 equal to €120 ml and a multiple equal to 4.716 the expected EV is equal to €566.0 ml, implying an exit equity value of €266.0. Thus the entry equity value is €71.6 ml. The affordable price is therefore €471.6 ml, or 4.716 times EBITDA.
Giuliano Iannotta – IEMIF – Università Bocconi
HEDGE FUNDS: RISK ARBITRAGE INTRO
Hedge funds specialized in risk arbitrage make a living betting on mergers. Once a deal is announced, the “arbs” take position: they go long on the Target’s shares and short on the Bidder’s shares. This position is at the risk of the deal not at the risk of the market. Suppose a stock deal is announced with exchange ratio (ER) equal to 1. The Bidder and Target stock prices (post-announcement) are €10 and €8 respectively. The difference between the current Target’s price and the bid price offered by the Bidder is the arbitrage spread: in this case the arbitrage spread is equal to €2. Because ultimately you can get one Bidder’s share (€10) with a Target’s share (€8) the arbitrage spread is a potential profit. This profit is juts potential because the arbitrage spread may narrow and/or disappear as the likelihood of the merger increases or due to change in market prices. The arb’s problem is to maintain the spread until the merger is consummated. The arb sells short one Bidder’s share, getting €10, and buys one (since the ER is 1) Target’s share, paying €8, thereby indirectly acquiring one Bidder’s share (if the merger succeeds): he now gains €2. What can happen at the closing? Scenario 1 – The Bidder’s price drops at €7. Since the ER is 1, the price of one Target’s share will be also €7. The arb sells the Target’s share for €7 with a result equal to -€1 (€7 - €8) and covers the short at €7 gaining €3 (€10 - €7). The net profit per share is then equal to €2.
A SIMPLE EXAMPLE
Scenario 2 – The Bidder’s price rises at €13 and the price of a Target’s share will also be €13. The arb sells the Target’s share at €13 gaining €5 (€13 - €8) but covers the short at €13 realizing a loss equal to -€3 (€10 - €13). The net profit per share is then equal to €2. !!! – At the closing of the merger the profit from the long position is: (p(B) - €8), while the profit from the short position is (€10 – p(B)). The net profit is €2 for any p(B). Whatever happens to the market prices the arb gets its spread. The arb just bets on the successful consummation of the deal. Suppose the merge of the previous example fails: this would produce a rise of the Bidder’s price (say to €11) and a drop in the Target’s price (say to €7): a pattern opposite to the one usually observed at announcement. What’s the result for the arb? He looses -€1 (€7 - €8) from the long position and looses also from the short position -€1 (10€ - €11), for a total loss of -€2. The main risk for the merger arb is that the deal may not go through: this risk is particularly high in hostile tender offer (due to competing bids of just to the failure of the offer). !!! – Notice that a merger arbitrage position can be created also in cash deals, simply purchasing the Target’s shares (and thus betting on the deal completion).
ANOTHER EXAMPLE
Suppose a stock deal is announced with ER equal to 2. The Bidder and Target stock prices (post-announcement) are €5 and €9 respectively. Given these prices, the arbitrage spread is equal to €1. Indeed, one would think about buying one Target’s share at €9 in order to eventually get 2 Bidder’s share valued at €10 and make a profit of €1. The arbitrage position is created selling two Bidder’s shares and buying one Target’s share. In general the number of shares to short is the hedge ratio times the number of shares held long. The hedge ratio is the exchange ratio. The profit for the arbitrage position is then: (2·p(B) - €9) + (2·(€5 – p(B))). !!! – A change in the exchange ratio is another risk for the arb, because it would leave a previously hedged position partly at risk. The arbitrage spread is an indicator of the likelihood of consummation. Indeed, the current stock price can be seen as the probability-weighted average of two outcomes: i) the deal is consummated and the Target’s shareholders get the bid price and ii) the merger fails and the Target’s price is at its stand-alone level. A proxy of the stand-alone price level could be the pre-announcement Target’s price (assuming the price does not impound any expected bid). Solving for Prob gives the market’s view about the likelihood of consummation.
pCurrent (T ) = Pr ob ⋅ pBid (T ) + (1 − Pr ob) ⋅ p Alone (T ) INTERPRETING ARBITRAGE SPREADS
Pr ob =
pCurrent (T ) − p Alone (T ) PBid (T ) − p Alone (T )
!!! - When arbitrage spreads are negative, the current Target’s share price is above the Bidder’s offer. It means that arbs and other investors expect a higher offer to be announced soon. The table shows the estimated probabilities of deal closing based on an analysis of arbitrage spreads. !!! – Data about four pending deal at July 18, 2003
Bidder
Target
Price Current
Bid
Pre-Bid
Arb. Spread
Probability
Oracle
PeopleSoft
17,82
19,5
15
1,68
62,67%
ArviMeritor
Dana
15,54
14,99
11,5
-0,55
115,76%
Higher Bid
Berkshire Hathaway
Clayton Homes
13,01
12,5
11
-0,51
134,00%
Higher Bid
Palm
Handspring
0,99
1,45
0,85
0,46
23,33%
Giuliano Iannotta – IEMIF – Università Bocconi
HEDGE FUNDS: RISK ARBITRAGE (TWO MINI-CASES)
SANITEC (cash deal) 22/5/01
Target: Sanitec Oyj (Finnish bathroom ceramics manufacturer) Bidder: BC Partners (European private equity investor) Date Event
11/6/01
26 April 2001
BC Partners offers EUR 14.60 in cash per Sanitec’s Share
27 April 2001
Filings by BC Partners (Finnish Stock Exchange, EU and US regulators)
10 May 2001
Offer document published and offer period starts
7 June 2001
EU clears transaction (First closing date)
11 June 2001
Receive consideration for Sanitec shares
19 June 2001
Second closing date
21 June 2001
BC Partners announces it controls 98.85% of Sanitec
Buy 100 shares of Sanitec @ 14.44 Receive consideration for Sanitec shares Profit
-€1,444 +€1,460 +€16
Buy 200 shares of Liberty Surf @ 7.332 Sell short 73 (0.365·200) shares of Tiscali @ 14.978 Borrowing cost on Tiscali short position @ 20% Interest on short sale proceeds @ 5% Receive consideration for Liberty Surf shares Profit
-€1,466 +€1,093 -€20 +€5 +€426 +€38
LIBERTY SURF (stock deal) Target: Tiscali SpA (pan-European Internet service provider) Bidder: Liberty Surf Group SA (French Internet service provider) Date Event
23/3/01 23/3 – 26/4
8 January 2001
Tiscali offers 0.365 shares and EUR 2.13 in cash per Liberty Surf share
31 January 2001
Offer documents filed with French market authorities for approval
12 March 2001
Tiscali’s shareholders approve capital increase and acquisition
22 March 2001
Offer document published and offer period commences
26 April 2001
Offer period closes, receive consideration, collapse short position
11 May 2001
Tiscali confirms that it controls 94.5% of Liberty Surf
26/4/01
!!! - XXX
Giuliano Iannotta – IEMIF – Università Bocconi
