Table of Contents
I. EXECUTIVE SUMMARY
II. LIST OF FIGURES
III. LIST OF ABBREVIATIONS
2. PRIVATE EQUITY IN GERMANY - BASICS
2.1 DEFINITION OF PRIVATE EQUITY
2.2 HISTORY OF PRIVATE EQUITY
2.3 BENEFIT OF INVESTMENTS FOR PRIVATE EQUITY COMPANIES
2.4 ECONOMIC IMPACT OF PRIVATE EQUITY
3. PRIVATE EQUITY INVESTMENT
3.1 PRIVATE EQUITY INVESTMENT FROM A COMPANY´S VIEW
3.2 PRIVATE EQUITY INVESTMENT FROM AN INVESTOR´S PERSPECTIVE
3.3 STAGES OF PRIVATE EQUITY INVESTMENTS
3.4 PRIVATE EQUITY TRANSACTION PROCESS
3.5 DUE DILIGENCE
3.6 BUSINESS VALUATION
3.7 DIVESTMENT PHASE AND EXIT
VI. ITM CHECKLIST (360-DEGREE ANALYSIS)
I. Executive Summary
The majority of companies are in need of investment capital to pursue their growth strategies. Also, a large number of companies only display a low equity ratio and as a result possess bad credit worthiness. In this regard, Private Equity represents a good alternative solution providing investment capital. It allows companies to make investments to solidify or improve their position among the competitors on the market. In times where banks and credit institutions exercise restraints, the interest of companies in Private Equity even increases. Nevertheless, particularly in Germany the growing importance of Private Equity is accompanied by great controversy. One group argues that often the Private Equity investors in their function as majority shareholders neglect the sustainable development of their portfolio companies in favor of their temporary value increase. On the other hand numerous studies indicate that companies benefit from Private Equity investments. According to these studies, companies, which have entered cooperation with Private Equity investors, comparatively, display stronger revenue growth and productivity and also generate more jobs.1
In this respect, the quality of the partnership between the portfolio company and the Private Equity investment association is a decisive success factor and must not be underestimated. Private Equity deals only generate win-win-situations if both parties are professionally engaged. Lack of preparation can either lead to a one-sided relationship - leaving one party at a disadvantage -, or even to a bad overall business, in which both sides incur losses.
This paper takes the perspective of each party and points out which specific aspects they have to consider in order having good chances of benefiting from a Private Equity deal. This leads to the analysis of several critical stages within the investment process: investment stages in general, transaction process, due diligence, business valuation and exit. Prior the meaning, history and significance of Private Equity are described.
II. List of Figures
Figure 1: Classification Private Equity
Figure 2: PE Investment and Fundraising Development in Germany
Figure 3: PE Financing Stages of Companies
Figure 4: Stages Prior to Due Diligence
Figure 5: Main Transaction Process and following Phases
Figure 6: Fields of Due Diligence
Figure 7: Free Cash Flow of Continental AG
Figure 8: Formula for WACC
Figure 9: Determination of Business Value with the DCF-Method
Figure 10: Exit Strategies of PE investments
III. List of Abbreviations
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The Private Equity industry has come a long way in Europe - from the 1970s where the institutional market started to establish itself to its rise in the 1990s and its volatile performance in the 21st century. However, in the recent years private equity capital has become increasingly interesting for a certain group of companies. This is partly related to the fact that banks have become more and more hesitant to grant loans - not only during financial crisis as the recent credit crunch, also due to the effects of Basel II. Partly, PE investment associations managed to fill the gap credit institutions left, attracting especially SME and Start-Ups, but also established companies for various reasons.2
One of the true advantages of PE investment lies in the increase of the company´s equity capital and the improvement of their balance sheet structure, which again has a positive impact on their credit ratings and their negotiating position. But perhaps even more important, it provides stability and liquidity during investment-intensive years. As a result companies are able to develop their products and grow continuously. On the other hand, with PE capital established companies are in the position to manage transitions such as geographical expansion or restructuring more efficiently and effectively.
But as the public discourse on finance investors and the PE industry indicates, the relationship between PE investment associations and the portfolio company is not always about peace and joy. And the win-win-situation which the PE industry often proclaims is to be questioned.
Against this backdrop, this paper assesses the PE investment process from various angles. Starting point is a brief definition of PE and overview of its history followed by the economic impact of the PE industry. On this basis a close up focus on the perspective of both parties - the PE investor and the portfolio company - and their specific requirements is taken. In a further step the stages of the investment process in general, as well as the transaction process in detail are described. Considering their critical value the due diligence and business valuation are separately evaluated. At last, the exit strategies of PE investment are drawn up.
2. Private Equity in Germany - Basics
This chapter gives an overview of the function of PE. By defining PE, at first, a common understanding for the further scientific discourse is established. Secondly, a short glance at PE´s history will be taken, while the emphasis is on Germany. Based on this, it is pointed out how PE companies benefit from equity deals. Finally, the aims of PE or better yet the usage of PE funds are described.
2.1 Definition of Private Equity
The term Private Equity was not characterized by science, instead it was established in the Anglo-Saxon finance world. In addition, neither in science nor in the public discussion the term is used in a uniform manner. First, PE is used as generic term for all types of private equity capital: this includes i.a. Venture Capital, Buyouts and Mixed Financing.3 While Venture Capital represents the finance of young companies with high growth potentials and high risks, Buyouts are understood to be takeovers of already existing companies. Furthermore, PE is used synonymously for Buyouts.4
The understanding of PE also varies in terms of the recipient of PE capital, which ideal- typical is supposed to be a non-listed company, although there is no reason why listed companies per se should be left out of PE.5 Concerning financing, there is also a narrow and a broad understanding as, according to the experts, PE not only includes pure equity capital - in consequence the investment companies become associates -, but also related types of financing, such as Mezzanine Capital, which is very common in practice.6
In general PE can be described as the providence of liable equity capital or equity capital-related funds for companies by third outside the stock market (fig. 1).
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Figure 1: Classification Private Equity
2.2 History of Private Equity
In recent years PE has become an important element of the financing spectrum of private companies. Especially in Europe this financing instrument has gained increasing relevance over the last decade.
In German-speaking countries PE has only started to play a noticeable role in the 90s.7 PE originates from the USA, supporting young and innovative companies financially in order to profit from their development. Here, institutional investors and wealthy private investors made the first positive experiences with this type of investment since the 40s.8 In Europe the PE market started to develop in Great Britain in the 70s. Since then the USA and Great Britain have taken a pioneering role in terms of PE and to the present hold the most active markets.9
Similar to the US-American model, in Germany the first investment companies were founded by private investors and private banks in 1965.10 However, due to their inexperience numerous companies could not manage sustainable success. A new era in the PE market was initiated by founding the Deutsche Wagnisfinazierungs-Gesellschaft mbH in 1975, which concentrated on Early-Stage-Venture-Capital - a novelty in Germany at that time.11 Generally, credit institutions made important contribution to the development of the PE market, owning the majority of PE companies in the 70s.12 While the 80s were characterized by increased foundation of Venture Capital associations as well as stronger financing and fundraising of the early-stage segment, for various reasons such as missing exit channels and lack of specialization the breakthrough of PE did not occur until the mid 90s. From 1996 on the German PE marked registered an exponential growth caused by the establishment of the Neuer Markt, the taxation of capital reform and the worldwide PE-Boom. At the end of the 90s the market expanded to a multiple of its original size, which also increased the investment volume of the PE segment drastically.13
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Figure 2: PE Investment and Fundraising Development in Germany14
When the Neue Markt collapsed, at the same time the boom of the PE market also ended causing a consolidation lasting several years..15 After the consolidation phase the volume of investments and fundraising increased again, reaching their pike right before the worldwide financial crises affected the PE market (fig. 2).
Today the investment volume has recovered from the financial crisis and is nearly at the level of the boom during the Neuer Markt era. Despite its relatively young history of 40 years the German PE market is considered to be one of the biggest and most important markets in Europe.
2.3 Benefit of Investments for Private Equity Companies
Obviously, PE companies are seeking advantages by financing target companies. Starting point is that by investing funds in private companies PE investment associations become majority owners of these companies and are able to shape their corporate strategies.16 This i.a. gives them the opportunity to increase the value of these companies. The idea is to achieve capital gain with current earnings. Yet, the PE companies generate their main return by selling their corporate shares after these have reached multiple value of the original investment to a successor as they are not interested in long-term investments.17. Common exit channels are:
- corporate shares are sold to an industrial investor (trade sale),
- corporate shares are sold to another PE company (Secondary Buyout),
- target company goes public (IPO).
- former shareholders buy corporate shares back (Buy Back)18
The returns in the PE sector are widely discussed among experts.19 While some studies reveal that PE funds outperform on average other asset classes20, others point out that considering the higher risks that PE investments carry only the best PE companies manage to outperform other asset classes.21 Although the worldwide financial crisis and credit crunch had a considerably negative effect on PE returns, the industry already has taken countermeasures by increasingly shifting toward fundamental value creation and therefore has the potential to perform again on a higher level.
2.4 Economic Impact of Private Equity
In several ways PE makes positive contributions to the economy.22 Primarily its role lies in channeling available equity capital to companies that have no access to public equity markets. Private equity also enables companies to enter the private equity domain, which find success under the spotlight of public capital markets difficult.23 In both cases PE turns out to be significant, particularly for companies, which have not established themselves yet or are facing transformational challenges in order to survive. PE is a financing instrument that addresses young companies focusing on corporate growth. By investing in new technologies and innovative concepts PE fosters innovation, generates high-skilled jobs and more fundamental - it creates new employment and new wealth. But PE also serves established companies well, which execute structural changes as it secures employment and creates value. Furthermore, PE is an appropriate means to improve the equity ratio of companies, resulting in higher credit ratings and better negotiation positions.
Another important function of PE goes along with being an asset class. By investing in PE institutional investors (e.g. pension funds, banks, insurance companies, government agencies) and private investors have the opportunity to optimize their investment returns while adding the PE asset class to their portfolio. By mobilizing private capital from investors and diversifying individual investment risk through portfolio orientated fund structures PE equity fulfils an important role in the overall capital market.24
3. Private Equity Investment
This chapter focuses on the process of PE investments. Central point is the transaction process and its stages due diligence and business valuation. But first it scrutinizes both parties of a PE deal - the PE investment association and the target company - and points out what they have to consider in order for the financing process to be a success story. Secondly, the different investment phases are shown. This is followed by the description of the transaction process. In the opinion of experts the quality of the Due Diligence has a significant impact on the success level of a PE deal. In this regard, the paper also assesses the role of due diligence before it turns to the significance of the subsequent business valuation. Finally, it briefly examines the different exit strategies during the divestment phase.
3.1 Private Equity Investment from a Company´s View
There is no doubt about the economic importance of PE, yet all that glitter is not gold. In the past PE companies often have been criticized for their radical approach - at least this is what they are accused of. The words of former SPD Chairman Franz Müntefering spoken in 2005 still are connected to finance investors and the PE industry as he compared them to locust swarms as they invade companies, graze them and shortly after move on. Regardless of whether Müntefering referred to a serious problem or not, at that time he opened up the opportunity to question the politics of the PE industry. The recent financial crisis has drastically increased the critical voices, often at the expense of an objective discussion, as investors are all lumped together. However, differentiated criticism is important, because it gives companies seeking capital some indication on what possibly speaks against a PE financing or better yet what needs to be considered. In the following, four substantial points of criticism are described. Afterwards it is pointed out, what companies have to pay attention to while seeking PE capital and negotiating with a PE association.
Often PE as an asset class is labelled to generate the highest returns on the capital market. One of the main strategies of PE companies to create value is active ownership.25 In this context acquisitions, divestment, value creation plans, process optimizations, close downs of unprofitable company parts are common.26 Quite frequently this leads to significant changes in the culture of the company, but more importantly is accompanied by job losses. The fact that top managers, which are integrated into an Equity Incentive Plan, receive a multiple of their manager salary after a transaction is successfully concluded is to be questioned.27 Further incentives are tied to the company’s increase of value - a double-edged matter because quick success is not necessarily in the best interest of a company in the long run. This applies particularly to SME and family businesses. While they have a long-term focus, PE investment associations have to satisfy the return-oriented investors and pursue short-term goals.28 Another important point of criticism is tied to the circumstance that PE investment associations pay the purchase price with debt capital, while repayment and interest are imposed on the acquired companies.29 Depending on the business situation high liabilities and interest payments can threaten their existence. Finally, the not so uncommon method of loading companies with additional capital to assure their investors further dividend payments is a problem.30 The risk shifts in favour of the PE association and increasingly burdens the company. This policy is even strongly criticized within the PE industry.31 Still, it is practised with a rising trend.32
Companies which are thinking about PE financing have to keep these common procedures in the back of their minds. But they also have to weigh system-based restrictions of PE financing. As a result they have to deal with a number of fundamental issues regarding strategy, objectives, policy and finances prior to the financing process.
1 In the studies the revenues of PE financed companies are compared to those of Non-PE financed companies, cf. Deutsche Beteiligungs AG (2004), p. 16; Schäfer/Fisher (2008), pp. 55; PWC/BVK (2005), p.9.
2 Cf. European Commission (2006), p. 14.
3 Cf. Ernst (2010), p. 4.; Jesch (2004), p. 22.
4 Cf. Ernst (2010)., p. 5.
5 Cf. Gündel/Katzorke (2007), p. 27.
6 Cf. ibid., p. 27.
7 Cf. Gündel/Katzorke (2007), p. 44; cf. Hess (2007), p. l6.
8 The first investment companies were founded at the end of the second World War, cf. Frommann/ Dahmann (2005), p. 11.
9 Cf. Gündel/Katzorke (2007), p. 40.
10 Cf. Leopold/Frommann/Kühr (2003), p. 42
11 The WFG was founded by 27 credit institutions under the leadership of the Deutsche Bank and invested about 70 million DM during 10 years of activity, cf. Frommann/Dahmann (2005), p. 12; Gündel/Katzorke (2007), p. 43
12 Cf. Gündel/Katzorke (2007), p. 42.
13 At the end of the 90s approximately 400 PE companies existed in Germany, cf. Frommann/Dahmann (2005), p. 13.
14 Cf. BVK., available under: http://www.bvkap.de/privateequity.php/cat/172/title/Interaktive_Charts, accessed 10th of July 2011.
15 Cf. Hess (2007), p. 17.
16 Cf. Fröhlich (2006), p. 5; cf. Blum (2008), pp. 36.
17 In the scientific literature concerning the investment period the information varies from between 2-5 years and 3-7 years, cf. Gündel/Katzorke (2007), p. 30; Fröhlich (2006), p. 5.
18 Fröhlich (2006), p. 5; Hess (2007), pp. 36.
19 Cf. Heel/Kehoe (2005), pp. 24; cf. Meerkatt/Rose (2006), pp. 2; cf. Acharya/Kehoe/Reyner (2008); Meerkatt et. al. (2008), pp. 9; cf. Frommann/Dahmann (2005), pp. 61; cf. Ernst (2010), pp. 25.
20 Cf. Frommann/Dahmann (2005), pp. 61.
21 Cf. Meerkatt et. al. (2008), pp. 11.
22 Speech of Deutsche Bundesbank board member Dr. Alfred Dombret at the 12. Eigenkapitaltag des BVK on the 12th of May 2011, cf Dombret (2011), available under: http://www.linguee.de/deutsch- englisch/search?sourceoverride=none&source=auto&query=vorstandsmitglied, accessed 20th of July., cf. Schefczyk (2004), pp. 28.
23 Cf. European Commission (2006), p. 14.
24 Cf. Ibid., p. 13.
25 Cf. Heel/Kehoe (2005), p. 25.
26 Cf. Fröhlich (2006), p. 6.
27 Cf. ibid. (2006), p. 6.
28 Cf. Schmittmann (2008), p. 28.; PWC (2007), p. 14.
29 Cf. ibid., p. 29; cf. Fröhlich (2006), p. 6.
30 Cf. Heinmann (2006), available under: http://www.handelsblatt.com/unternehmen/handel-dienstleister/ riskanter-griff-in-die-kasse/2693014.html, accessed 20th of July, cf. Fröhlich (2006), p. 6.
31 Renown PE associations such as Kohlberg and Kravis Roberts in principle abandon recapitalization policy, cf. Fröhlich (2006), p. 6.
32 The sum of dividend-recapitalization increased tenfold between 2002 and 2005 to more than 40 Billion Euros, cf. Heinmann (2006), available under: http://www.handelsblatt.com/unternehmen/handel- dienstleister/riskanter-griff-in-die-kasse/2693014.html, accessed 20th of July, cf. Fröhlich (2006), p. 6.
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- FOM Essen, Hochschule für Oekonomie & Management gemeinnützige GmbH, Hochschulleitung Essen früher Fachhochschule
- Private Equity Investment Due Diligence Business Valuation Transaction