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Private equity

Private equity. Introduction. Private equity , by opposition to public equity, refers to shares in companies that are not publicly traded Private equity includes venture capital (VC) and buyouts

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Private equity

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  1. Private equity

  2. Introduction • Private equity , by opposition to public equity, refers to shares in companies that are not publicly traded • Private equity includes venture capital (VC) and buyouts • Investors (pension funds, wealthy individuals…) invest in private equity funds, which usually control the management of the private equity firms in which they invest • The company in which the private equity is made is called the portfolio company

  3. Pension funds Wealthy individuals Banks … IB Private equity funds IB IB Venture Capital Buyouts …

  4. Investment banks may either raise money for a private equity fund, or manage the fund itself • Substantial entry costs ($100,000+) • Illiquid investment (10-12 years maturity) • If there are no good investment opportunities, the capital can be returned to the investors • Very high risk, uncertain but potentially high return

  5. Facts about the private equity business • $135bn was invested globally in 2005 • Buyouts generate 67% of private equity investment in 2005 • Regional breakdown in 2005: • US 40% • UK 22% • France 7% • Asia-Pacific 11% • Data http://www.ifsl.org.uk/pdf_handler.cfm?file=CBS_Private_Equity_2006&CFID=557241&CFToken=17550722

  6. Advantages of private equity over senior debt Young companies cannot easily obtain bank loan (high interest rate, collateral required). Issuing public equity is most often not feasible. Solution: Private equity, although it might imply giving away most of the equity. Benefits: - The issuing company benefits from the private equity firm experience - The private equity firm will work hard to ensure that the company succeeds. This is not the case with bank loans

  7. Fees and profit allocation • VC funds charge 1.5-2.5% of capital commitments per year. • Trend: reduction of management fees, high degree of fees clustering • Typically: 20% of profits go to the general partner (private equity firm), 80% go the limited partners (investors) • Reputable VCs charge higher fees

  8. Venture capital • Companies need to raise funds in order to expand, invest, and develop • Two possibilities: Issue debt, or issue equity • Often, small companies can hardly issue debt: too risky, too costly • Solution: private equity

  9. VC firms make equity investment in entrepreneurial companies. They pool funds from a variety of investors and invest in these companies. • VC realize its returns when the companies go public or are sold out to other businesses. • VC funds typically live 10-12 years, from fund raising to liquidation. • VC funds are actively involved in the portfolio companies.

  10. Entrepreneurs and reputable VC (Hsu, 2004, Journal of Finance) • A financing offer from a high-reputation VC is three times more likely to be accepted by an entrepreneur. • High-reputation VCs acquire start-up equity at a 10-14% discount. Entrepreneurs are willing to accept lower offers in order to affiliate more reputable VCs. Suggests that VCs are more than strict financial intermediaries.

  11. Leveraged buyouts (LBOs) • LBOs consist of using borrowed money for a substantial portion of the purchase price of the buyout company • LBO firms use other people’s money, borrowing from banks • The assets of both the selling company and the acquiring company typically secure the debt. Consequently, LBOs involve low-tech businesses with a history of consistent profitability and low debt • Thanks to high leverage, the buyout firms enhance their potential investment return

  12. Typical buyout financing structure: 50-70% of senior debt 15-30% of subordinated financing 10-20% of equity • Critics: LBOs result in massive layoffs, lower tax revenues. • Reality: LBOs are tools of economic reorganization, and induce risk-taking.

  13. Performance of private equity funds Hypothesis: Private equity is risky the return should be high Is it the case? Moskowitz and Vissing (2002) • The returns to private equity are not higher than the return to public equity between 1952 and 1999 • 10-year survival rate of 34% for private firms • Conditional on survival, the distribution of return is wide

  14. Kaplan and Schoar (2005) • Buyout funds returns are slightly less then public equity funds • VC funds returns are similar to public equity funds • Private equity funds returns are persistent (unlike public equity funds) • Fund flows are positively related to past performance

  15. Phalippou and Gottschalg (2006) • Gross-of-fees private funds outperform the S&P 500 by 2.96% a year. Net of fees, they underperform the S&P 500 by 3.8% a year. • Why do investors buy private equity? • There are side benefits of investing in private equity funds, such as the establishment of relationship with an IB (for debt and equity issues, M&A consulting etc.). • Some agencies invest in private equity to stimulate the local economy (e.g. some European Union agencies).

  16. Gross-of-fees performance of GP’s VC investments • Most often, results are that they outperform the stock market • Possible bias since performance is often not observed for unsuccessful investments Cash-flow stream from funds to and from LPs

  17. Phalippou and Gottschalg (2006) Particularity of the paper: • Data on cash-flows to/from invetors in private equity (852 funds) • Data on the proportions of investments exited vias IPO or M&A (852+727 funds) • Having out-of-sample funds allows to measure the bias due to unobserved negative performances • The dataset covers funds raised between 1980 and 2003

  18. Measures of performance: • Profitability index (PI): PV of the cash flows divided by the capital paid by investors. The discount rate is the S&P 500 return • Internal rate of return (IRR)

  19. Table 1 • Outperformance for buyout funs, underperformance for VC funds. • Most of the funds have below average performance Table 2 • Out-of-sample funds are smaller • Out-of-sample funds have fewer investments exited via IPO or M&A

  20. Table 6: Exit rate and performance • Positive relationship between exit success and PI - Out-of-sample funds have thus lower performance, the PI is 0.11 to 0.14 lower on average • Performance estimates based on funds for which cash flow information is available are thus overstated Table 4 • Writing-off residual values reduces the PI well below 1 • The average yearly alpha is -3.83% - Significant performance difference between buyout (PI=0.91) and VC funds (PI=0.81). However the alphas are similar.

  21. The impact of fees There are other fees that are not taken into account in performance measures: • 20% of investors hire gatekeepers • Investors without gatekeepers soend resources on screening funds • If investors need to liquidate their position before the fund closure, a penalty is charged • Distributions are often made in shares, not in cash The gross-of-fees alpha is estimated at 3%, so the total impact of fees is 6.7%

  22. Performance persistence (table 10) • More experienced funds perform better • Significant performance in funds performance • Low performance could be explained by the fact that investors need to learn how to identify performing funds

  23. Analyze analysts’ conflicts of interest during IPOs 391 IPOs Distinction between recommendations by the lead manager of the IPO and other brokerage firms Hypothesis: The market responds relatively less to the buy recommendations of underwriters Table 5: The market reaction (excess return) depends on the underwriting relationship Table 5: Returns of firms with underwriter recommendations declined 1.6% in the 30 days prior to a buy recommendation Michaely and Womack (1999)

  24. Table 5: Strong divergence for the long-run excess return Table 6: The long-run IPO performance depends mostly on buy recommendations from non-underwriters Underwriter buy recommendation have a significant short-term impact of stock prices, suggesting that the market does not fully recognize the bias

  25. Analysis of earnings forecasts in the US (1984-2000) Hypothesis: Analysts are averse to negative earnings surprise. Early in the reporting period, analysts’ estimates are biased upwards, and they are adjusted downward over the period Table 1: Between 1984 and 2000, 48% of earnings exceed the consensus, 40% are below the consensus and the rest equal to the consensus Table 4: The market reaction to earnings surprises has climbed steadily up to late 1990s. The market is particularly sensitive to negative surprises. The market is more sensitive to surprises than to revisions Chan et al. (2003)

  26. Table 9: For independent analysts, the average surprise is lower than for non-independent analysts Table 10: International evidence. The trend towards more positive surprises is less pronounced outside the US

  27. Evidence on the performance of private equity

  28. BVCA private equity performance survey • Survey of UK private equity funds performance (2005) • 362 funds in total • The returns are derived from cash flows to/from investors mostly • IRR measure of performance, net of fees • Result: UK private equity outperforms the FTSE over the medium and long-run • Net return: Three years: 21.1% p.a. Five years: 11.9% p.a. Ten years: 16.4% p.a.

  29. Phalippou and Gottschalg (2006) Particularity of the paper: • Data on cash-flows to/from investors in private equity (852 funds) • Data on the proportions of investments exited via IPO or M&A (852+727 funds) • Having out-of-sample funds allows to measure the bias due to unobserved negative performances • The dataset covers funds raised between 1980 and 2003

  30. Measures of performance: • Profitability index (PI): PV of the cash flows divided by the capital paid by investors. The discount rate is the S&P 500 return • Internal rate of return (IRR)

  31. Table 1 • Outperformance for buyout funds, underperformance for VC funds. • Most of the funds have below average performance Table 2 • Out-of-sample funds are smaller • Out-of-sample funds have fewer investments exited via IPO or M&A

  32. Table 6: Exit rate and performance • Positive relationship between exit success and PI - Out-of-sample funds have thus lower performance, the PI is 0.11 to 0.14 lower on average • Performance estimates based on funds for which cash flow information is available are thus overstated Table 4 • Writing-off residual values reduces the PI well below 1 • The average yearly alpha is -3.83% - Significant performance difference between buyout (PI=0.91) and VC funds (PI=0.81). However the alphas are similar.

  33. The impact of fees There are other fees that are not taken into account in performance measures: • 20% of investors hire gatekeepers • Investors without gatekeepers spend resources on screening funds • If investors need to liquidate their position before the fund closure, a penalty is charged • Distributions are often made in shares, not in cash The gross-of-fees alpha is estimated at 3%, so the total impact of fees is 6.7%

  34. Performance persistence (Table 10) • More experienced funds perform better • Significant persistence in funds performance • Low performance could be explained by the fact that investors need to learn how to identify performing funds

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